Another ‘sell in May’ looming for stock markets?

25 April 2017

Report by David Cheetham

David Cheetham

  • Could now be the right time to short sell the S&P500, DAX30 and FTSE100?
  • Could the equity markets be overvalued and facing a correction?
  • What technical signals used to cause market declines in the past?
Intro
‘Sell in May and go away’ is a well-known trading proverb that’s based on the historical underperformance of stocks in the six-month period between May and October, compared to the six-month period of November to April. Some traders believe that May is not a good month to hold long equity positions and weakness could extend all the way throughout the summer. In this report, we analyse whether this is an accurate strategy but also take a broader view on three popular instruments: US500 (S&P500 underlying), DE30 (DAX30 underlying) and UK100 (FTSE100 underlying) to measure each index’s prospects going forward. Finally, we look at technical signals that could justify considering a short position on these markets.

Sell in May… or in June?
Seasonality should not exist on equity markets in theory, because equity valuation is free from calendar fluctuations in demand or supply let alone weather patterns. Yet some months have been historically better than others. If the proverb was true, we could expect average negative returns in May, followed by lackluster summer months. Choosing a proper sample however is very important to avoid biased results. Therefore, we’ve chosen to focus on the past 10 years (from April 2007 until March 2017) as this period includes long sequences of both bull and bear markets.

Despite a painful bear market of 2008, this period was decisively positive for stocks in US (+66%) and Germany (+78%, DE30 is a total return index though, so it includes dividends) and modestly positive in UK (+16%). Unsurprisingly, there were only three negative months on average for US500 and DE30 but as many as seven for the UK100.

Let’s begin with May: this month resulted in an average decline of 0.54% for the UK100 but it saw gains of 0.06% for US500 and as high as 1% for DE30. Therefore one cannot say that May has been poor for equities throughout the last decade. However, June tells a different story. June is the month were bears seemed the strongest over the past 10 years. It’s the worst month for the UK100 (-2.17% on average) and second worst for DE30 (-2.26%) and US500 (-1.52%). While the American index saw its worst month in January and the DE30 in August, June’s weakness seems the most uniform. For the DE30 it brought declines on 6 out of 10 occasions, plus in one month gains were minimal. Meanwhile for the US500 we saw six months with negative return and two with narrowly positive ones. Therefore, the data could point to sell in June rather than in May, or perhaps even “sell at the end of May”.

Average monthly return for the last 10 years

Please be aware that information and research based on historical data or performance does not guarantee future performance or results.

Despite a popular market proverb, it’s June that has been bearish so far during this decade. Data from April 2007- March 2017 for S&P500, DAX30 and FTSE100

 

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Are equity markets “a sell”?

Historical data points at a weak June for markets like the US500, DE30 and UK100. But could fundamental reasoning support such a call? We look at selected indicators for answers. Many traders begin this analysis with the price to earnings ratio. It is at 21.6 at present (24 April 2017) for the US500 compared to 17.6 average for a sample extending to 1980. However, the P/E ratio has some serious flaws as it could be high during recessions when some companies incur losses. A positive P/E is an alternative measure and it is at 20.65 at present for the US500 (compared to 15.85 average for the past 10 years, April 2007 - March 2017), 16.50 at present for DE30 (average 13.72, April 2007 - March 2017) and 26.73 at present for UK100 (average 14.65, April 2007 - March 2017). This measure could indicate some serious overvaluation, especially for UK100. For the US500 a positive P/E is at its highest level since 2002. Another interesting measure is price to sales as it offers more stability. This indicator cannot really be compared across markets as it depends on industry breakdown. However, we can compare it over time, and for the US500 current P/S ratio is 37% above the 10 year average (April 2007 - March 2017). For the DE30, this is 29.5% above and 10.6% above for the UK100. So again we could talk about overvaluation if considering this indicator only, although this time it’s relatively low for UK100. For the US500 and DE30 this measure is the highest it’s been in 10 years (April 2007 - March 2017).

Not all the indicators point at extreme valuations though. For the DE30 and UK100, dividend yields are still much above 10-year treasury bond yields. For the US500, dividend yield is slightly lower than the 10-year bond yield but the difference is smaller than over the past 10 years on average. While this approach has been criticised asset managers often hinted at this relationship as a reason behind the stock market rally over the past few years, so it’s worth a mention. Generally though, a majority of analysed metrics could suggest an overvaluation of those equity markets.

Technical signals to watch
Because major indices are not in bearish trends, some investors could prefer taking on positions only when a specific technical signal appears, even if the correction scenario seems to be backed by seasonality patterns. There are many technical patterns that could start a correction but we analysed the markets to see if there are any typical patterns, especially for the second quarter.

US500 - bearish engulfing are common reversal patterns and they historically started corrections on US500. Consider examples from 2011 - there is a strong engulfing at the end of May that ends a period of longer consolidation that capped a significant rally. Another formation can be spotted at the end of June - while it follows a small recovery, there could not be new highs. In both cases traders were selling highs here but not against a strong upward trend. Do notice that formations are clear (no significant shades) and the bearish (red) candle fully eclipses a previous (green) one. Similar patterns could be observed in Q1 of 2010 and 2013. Obviously there’s no guarantee that such behaviour or pattern could appear this year, there are also other factors to consider.

Source: XTB Research, xStation

Bearish engulfing pattern worked as correction signals on US500 in the past.


DE30 - this market really seems to be enjoying demand/supply zones. Consider an example from Q2 of 2014, where a supply zone around 10,000 points was tested throughout the whole quarter. A repeated failure to break higher resulted in a correction. Traders were able to clearly define their stop loss here above the tested zone. We saw similar behaviour on this market in the second quarter of each year between 2010 and 2014. Again, there’s no guarantee that such behaviour or pattern could appear this year, there are also other factors to bear in mind.

Source: XTB Research, xStation

Resistance zones have triggered a correction on DE30 in the past.


UK100 - a bearish cross occurs when a faster moving average (based on a smaller number of observations) moves below a slower one. We tested various moving averages from January 2010 until March 2017 and found that a 8 and 21 day bearish cross has worked well for the UK100 in the past. When such a cross occurred (43 times in this period of time so far), it resulted in a median decline of 4.3% measuring from the bearish cross signal itself to the local low ahead of the following (bullish) cross. Whilst this is significant, these statistics look even better if we focus solely on just the second quarter - in this case the median decline rises to 7.51%. Interestingly, as of the 24th April we have an active bearish cross on the UK100 market.

Source: XTB Research, xStation

A 8/21 day bearish cross worked particularly well during the Q2 on UK100 in the past.

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Obviously, there is no guarantee that signals which worked in the past will work this year. However, traders could treat them as an additional factors to consider when drawing their trading plans.

Conclusions
In this report we analysed seasonality on S&P500, DAX30 and FTSE100 over the past 10 years and found June to be the most bearish month. Some fundamental measures suggest that these markets could be overvalued. We also analysed some particular technical signals and found that bearish engulfing patterns have worked well for US500, resistance zones for DE30 and bearish crosses for UK100 so far during this decade.

Source: XTB Research

Traders on equity markets should consider to weigh long-term bull markets against seasonality and valuation concerns. Please be aware that information and research based on historical data or performance does not guarantee future performance or results.


Traders could consider checking our trade idea report from the “Q2 trade ideas” report which analyze SPA35 (Ibex35 underlying) against the US500 (S&P500 underlying) based on different potential scenarios within Europe and the United States.

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Past performance is not necessarily indicative of future results, and any person acting on this information does so entirely at their own risk. XTB will not accept liability for any loss or damage, including without limitation, any loss of profit, which may arise directly or indirectly from the use of or reliance on such information.

When XTB provides trading analysis and/or research, the author of this article may have an interest in the instruments mentioned. XTB has policies in place to identify and manage any conflicts of interest that may arise in the production of research and the provision of trading analysis.

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Trading CFDs on a leveraged basis involves significant risk of loss to your capital. They may not be suitable for everyone, so please ensure you fully understand all of the risks.

Trading CFDs on a leveraged basis involves significant risk of loss to your capital. Please ensure you fully understand all of the risks.

Trading CFDs involves significant risk of loss to your capital