It’s still a good idea to sell in May and go away

May.06, 2008 in Market Outlook

Risk management is the strategy of choice

By Todd Harrison

Last Update: 6:42 PM ET May 6, 2008

NEW YORK (MarketWatch) — Time is the ultimate arbiter of fate. This is
especially true in the financial markets.

A few summers ago at the Minyans in the Mountains Ojai retreat, we were
discussing the cumulative imbalances percolating under the seemingly calm
financial surface. In the middle of our panel debate, Tony Dwyer, the talented
strategist from FTN Midwest Securities, wryly opined “The sun is going to blow up
one day, but that doesn’t mean it’s a good trade.”

His wise words continued to resonate in my crowded head. I’ve always attempted to
operate as an optimist that believes negative energy is wasted energy. As a
trader, I’m equally aware that positive perspective and bullish positioning are
mutually exclusive dynamics.

With that in mind and given the spirited sprint that has distanced the market
from the March lows, I wanted to offer five reasons why “Sell in May and go away”
may indeed ring true by the time June rolls in.

Reverse M&A
During the meat of the financial heat since last summer, we said that increased
banking activity would bode well for market psychology. It stands to reason that
the unwinding of proposed deals could weigh on the collective sentiment.

Last week, after Bank of America (BAC) mentioned they might not back Countrywide
Financial Corp’s (CFC) outstanding debt, Standard & Poor’s promptly put some junk
in their trunk. We offered in Minyanville that this might have been a stealth
reason why the Federal Reserve proactively increased the size of the Term Auction
Facility and shifted their collateral standards

Over the weekend, the proposed marriage between Microsoft Corp. (MSFT) and Yahoo
Inc. (YHOO) hit the skids after the two tech titans couldn’t agree on price.
While their alliance would have been an intuitive fit for their digital media
aspirations, the value of those eyeballs remained an insoluble source of
friction.

While on opposite sides of the industry spectrum, these disparate situations
highlight a singular point. Mergers are more than a financial agreement between
two organizations; they’re a cultural one as well. Given the rough and tumble
landscape, societal acrimony has seemingly seeped into the innards of corporate
America.

Fear factor

In layman’s terms, volatility is the opposite of liquidity. Anyone who has
attempted to accumulate a sizable position in a thin stock can attest to this
fact. Conversely, an abundance of liquidity — such as the trillion dollar
Federal injection we’ve recently seen — flushes the market with supply, which in
turn dampens volatility.

This could be cause for pause for stock market bulls. The Volatility Index (VXO),
widely perceived to be a proxy for fear in the marketplace — has declined more
than 45% since Bear Stearns (BSC) imploded and anxiety gripped the street on
March 17th.

During previous fear fulcrums — such as the Thai Baht panic of 1998 and the
dot-com implosion of 2000-2001 — the VXO peaked near 60. Currently, despite the
housing depression, credit contagion, derivative machination and global
dependency of a finance-based economy, the VXO is flirting with the teens.

I’m of the view that long volatility (positive gamma) is the smartest bet in the
current market with the caveat that only those with a working knowledge of
options should assume that risk. See related item.
Click for Detail

The false sense of security

I’ve long viewed technical analysis as more of a context than a catalyst. In the
absence of clarity, however, traders tend to depend on charts and levels as
actionable influences.

As a function of last week’s lift, the stock market secured technical affirmation
above S&P 500 1,405, Dow Jones Industrial Average 12,800 and Transportation
5,000. Almost immediately, Wall Street sounded the “all clear” that it was safe
to wade back into exposure. This, mind you, after a double-digit gain by the
mainstay averages in less than two months.

A few points of perspective. Coming into this week, 77% of the S&P 500 stocks –
and 85% of the S&P financials — were above their 50-day moving averages, the
highest such reading since October. Further to that, Bennet Sedacca of
Minyanville notes that a combination of annual, decennial and presidential cycles
yields a potential “top date” for the S&P on May 8. Those were, so you know, the
same cycles that suggested a low on March 15th.

One of my favorite trading axioms is that we must respect — but never defer to
– price action in the marketplace. Investors would be wise to remember that as
we edge ahead and make our bed.

Iran

A few weeks ago, Adam Michael of Minyanville mused that the U.S. government was
topping off the strategic petroleum reserve during an election year when oil
prices were over $100. He also noted that Vice President Dick Cheney was in the
Middle East at the end of March and President George Bush met with Vladimir Putin
a few weeks thereafter. Something didn’t smell right to him and based on the
recent action in crude, we’re starting to understand why.

We’ve since learned that Israel bombed a Syrian nuclear reactor last year, the
U.S believes North Korea has been assisting Syria and the chairman of the Joint
Chiefs of Staff accused Iran of increasing its efforts to train and arm
insurgents in Iraq and Afghanistan.

With the saber rattling getting louder, it’s no wonder crude is back to all-time
highs. I’m unsure what the foreign agenda is but it appears that the Bush
administration is either attempting to get everyone to the negotiating table or
positioning for confrontation. Given the delicate global balance and geopolitical
tension, the latter could prove quite unsettling.

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