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Sell in May But Stick Around

May 6, 2013

by Christian Thwaites

of Sentinel Investments

A bit odd, perhaps, to worry about deflation as the S&P[1] hits all time highs. But the whiff of deflation is in the air. The YOY PCE core (the one the Fed likes) came in at 1.1% which is the lowest it has ever been. Here it is:

Source: Federal Reserve Bank of St. Louis, Economic Research

The PCE doesn’t affect things likeCOLA. It has component differences to theCPI, mostly in housing and medical. Its use as a policy tool is to separate out noise. Outright deflation tends not to occur much primarily because of wage and price stickiness, especially with leveraged companies. How? In the first case, employees will take a 10% reduction in the workforce over a 10% reduction in wages. The clearing mechanism to lower wages can work through the labor market but takes time. And in the second case, any company reducing prices to create demand puts immediate pressure on its P&L. Creditors then play rough on things like loan covenants. So that tends not to happen either.

The broad lesson is that deflation redistributes income from debtors, who have a high propensity to spend, to creditors, who don’t. So demand falls. And if the wage stickiness persists, then real labor costs increase. That’s why 2% deflation is a lot more pernicious than 2% inflation.

The central bankers know that and that’s why the Fed reaffirmed its commitment to QE citing “restraining” fiscal policy and “inflation” below target. A simple extrapolation of current inflation doesn’t get us to the 2.5% target until…2021. Over at theECB, Draghi mentioned the ever so remote possibility of cutting the deposit facility rate. Sounds ok, except the rate is 0%. So negative rates? He’s clearly trying to push banks to lend more but for now excess money will just go into sovereign bonds. Surprise, Bunds rallied hard on the news.

So put these together, and we have worryingly low inflation, low demand and sub-par job growth. Any monetary stimulus will remain.

Conventional Wisdom

Everyone knows the “Sell in May” rule. I originally heard (or misheard) the other half of it as "Buy again on Derby Day" (the British one) which is in June. But have also heard “Buy again on St. Leger Day” which is in September. Either way, the link with horse racing and investing is clear. Does it work? The most often cited period of outperformance is October to April which returned 6.7% from 1942 to 2010 compared to 3.5% for long-term trend growth. Trouble is that record was pretty dismal from 1886 to 1942. Another period that works over the longer period is February to August which has a far more consistent, albeit smaller, return premium over long-term trends. These rules can work but experience tells us that the best advice is “Sell in May, but be prepared to buy again at any time, and go away, but be prepared for a call back to your desk at any time.” Which some people say is not quite as catchy.

Sources : Bloomberg; Capital Economics; Federal Reserve Bank of St. Louis; High Frequency Economics; Federal Reserve Board; ISI; Pantheon MacroEconomic Advisors; The Chart Store; ECB; “Deflation, the New Threat?” Manmohan S. Kumar, IMF; Mainly Macro; Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

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