- Speaker #0
Hello, welcome back to Papers with Backtest podcast. Yeah. Today we dive into another algo trading research paper exploring the idea of sell in May and go away.
- Speaker #1
Oh yeah, that's right. A classic market saying.
- Speaker #0
It suggests that stock market returns are generally better between November and April. Right. Compared to May and October. Yeah. You know, it almost makes you want to just take those summer months off from trading altogether.
- Speaker #1
Well, maybe not quite that drastic, but, uh, you know.
- Speaker #0
So is there any hard evidence to support this phenomenon?
- Speaker #1
There's been a lot of research and discussion around this strategy. Yeah. And believe it or not, some academics actually claim it can be profitable.
- Speaker #0
That's interesting. So what are some of the potential explanations? What does the research say?
- Speaker #1
Well, one theory revolves around summer vacations.
- Speaker #0
Okay. So people are less engaged with the market when they're off on holiday.
- Speaker #1
Right. And one study published in the American Economic Review looked into this. Yeah. And they actually found a connection between the strength of the cell in May effect and the length and timing of summer vacations. The researchers initially thought this might indicate a change in risk aversion during vacation periods.
- Speaker #0
So people are more relaxed and less worried about their investments while they're, you know, sipping cocktails on the beach.
- Speaker #1
Right, exactly. But here's where things get a bit more complicated. The study also found that this cell in May effect was present in the southern hemisphere where summer vacations take place. place at a completely different time of year.
- Speaker #0
Ah, so that kind of throws a wrench in this simple vacation theory then.
- Speaker #1
It does. It seems there's more to the story. Yeah. And this led researchers to explore other explanations like the SAD effect, which stands for seasonal affective disorder.
- Speaker #0
Okay. SAD, seasonal affective disorder. Right. How could that potentially impact the stock market?
- Speaker #1
Well, the theory is that people's risk aversion might actually increase during the fall and winter months due to SAD. You know, shorter days, reduced sunlight can contribute to feelings of depression, which might in turn make people less inclined to take risks with their investments.
- Speaker #0
So the gloomy weather is kind of reflected in the market.
- Speaker #1
That's the general idea.
- Speaker #0
Got it.
- Speaker #1
But as with the vacation theory, there are some holes in this explanation as well. Oh, OK. Some research published in the Journal of Empirical Finance found that when you use a model accounting for variations in things like market risk and market price of risk, they could essentially capture. this S.A.D. effect.
- Speaker #0
So what does that mean in practical terms?
- Speaker #1
Well, it suggests that S.A.D. alone might not be a super reliable predictor of market movements or, you know, a profitable trading strategy. Yeah. And plus, some studies haven't even found a direct correlation between depression and changes in risk aversion. And others argue that depression actually peaks later in the year, which contradicts the whole sell in May pattern.
- Speaker #0
Yeah. Okay. So it seems like we're hitting a bit of a dead end with these theories. Yeah. It's not vacations. It's not SA. Right. So what else could explain the sell and may effect?
- Speaker #1
This is where things get really interesting. A working paper from the Rabobank Robico Institute for Research and Investment Services, IREs, proposes a concept called the optimism cycle.
- Speaker #0
An optimism cycle. Okay. I'm intrigued. Tell me more about this.
- Speaker #1
The idea is that Towards the end of each year, investors tend to look ahead to the new year with this heightened sense of optimism, expecting strong market performance. And this initial wave of optimism can lead to higher stock returns early in the year.
- Speaker #0
So it's almost like a self-fulfilling prophecy. The more optimistic investors are, the more they drive up prices.
- Speaker #1
Exactly. But then as the year progresses and those initial expectations are met with reality, this optimism begins to fade. OK. Often resulting in a lull in the market during those summer months.
- Speaker #0
So are you saying that the sell in May effect is driven by a shift in investor psychology? It could be. Rather than any fundamental economic factors?
- Speaker #1
That's one interpretation. And to test this theory, the researchers examined a global zero investment strategy. They essentially went long on cyclical stocks and short on defensive stocks during the winter period and then reversed those positions during the summer.
- Speaker #0
Wait. Can you just quickly clarify what a zero investment strategy means in this context?
- Speaker #1
Sure. It means that the total value of the long positions is equal to the total value of the short positions. Okay. So there's no net capital outlay.
- Speaker #0
Got it. Thanks for clarifying that. So back to the strategy that they tested. Right. What were the results?
- Speaker #1
The results were quite compelling. Okay. This strategy yielded a 7% annualized return over a 34-year period.
- Speaker #0
7% annualized.
- Speaker #1
With the largest drawdown being 27%.
- Speaker #0
Okay, 7% annualized, that's nothing to sneeze at. Right. Especially over such a long period.
- Speaker #1
Yeah, but a 27% drawdown, that could be tough to stomach for some investors. Right.
- Speaker #0
So it highlights the risk associated with any market timing strategy. For sure. So what can we learn from this? Is this optimism cycle theory? a solid foundation for a trading strategy.
- Speaker #1
The research suggests there's definitely something to it. The researchers attributed roughly half of the strategy's performance to market timing and the other half to a genuine seasonal sector effect.
- Speaker #0
Meaning that certain sectors tend to perform better or worse depending on the time of year?
- Speaker #1
Precisely. Okay. And they also found a seasonal pattern in analyst earnings growth revisions that mirrored this overall stock. market cycle.
- Speaker #0
So analysts were also getting caught up in this wave of optimism, then adjusting their expectations as the year progressed.
- Speaker #1
It appears so. Yeah. And this further supports the idea that investor psychology plays a role in shaping market dynamics.
- Speaker #0
Okay, interesting. So they've established a connection between investor sentiment and market performance. Right. But is there any way to measure this optimism directly?
- Speaker #1
That's a great question. And the researchers actually did try to find a more concrete measure. Okay. They decided to use the average initial return on IPOs or initial public offerings as a proxy for investor optimism.
- Speaker #0
Because when investors are feeling bullish, they're more likely to jump into those potentially high growth companies.
- Speaker #1
Exactly. And when they included this IPO return data in their analysis and almost completely explained the performance of their sector rotation strategy.
- Speaker #0
Wow. That's a pretty strong link. Right. It seems like investor optimism, as reflected in those IPO returns, is a key driver. of this sell in May phenomenon.
- Speaker #1
It certainly suggests that sentiment plays a significant role. And they found that the average initial return on IPOs during the winter period was significantly higher than during the summer, further supporting the optimism cycle theory.
- Speaker #0
So it all ties together quite nicely. Yeah. Investor optimism peaks at the start of the year, driving up IPO returns. And this optimism kind of spills over into the broader market. Right. Creating the conditions for the sell in May effect.
- Speaker #1
Precisely. And this brings us to a crucial question for traders.
- Speaker #0
Okay, what's that?
- Speaker #1
Are there any specific trading rules or variations of the sell in May strategy that could be applied based on this research?
- Speaker #0
Let's dig into that.
- Speaker #1
Well, the most basic implementation would be to simply be out of the market from May to October. Okay. And fully invested from November to April.
- Speaker #0
So kind of like a seasonal switch, flipping your portfolio on and off.
- Speaker #1
Yeah. You could say that. Right. But there are also more nuanced approaches that incorporate this optimism cycle and sector rotation.
- Speaker #0
Like the zero investment strategy we discussed earlier. Yeah. Going long on cyclicals and short on defensives during the winter. Right. Then reversing those positions in the summer.
- Speaker #1
That's one example. Yeah. And remember, they tested this globally, not just in a single market. Oh,
- Speaker #0
so they were essentially chasing that optimism wave around the world.
- Speaker #1
Exactly. They were in the northern hemisphere markets during their winter and then shifted to southern hemisphere markets during their summer.
- Speaker #0
Clever. But wouldn't transaction costs kind of eat into those returns, especially back then?
- Speaker #1
Yeah, that's a great point. It's something to always consider when implementing any strategy. Yeah. Especially one involving frequent trades. Right. Hard to say for sure what the impact would have been back then. Yeah. But with lower transaction costs these days, it could be more viable now.
- Speaker #0
OK, so that's one variation. Yeah. Are there any other trading rules that kind of stand out from the research?
- Speaker #1
The paper also explored sector specific variations within a single market. OK. So, for example, during the winter period, you could go long on companies in sectors that are expected to benefit from increased economic activity and investor optimism.
- Speaker #0
Things like consumer discretionary technology, maybe industrials.
- Speaker #1
Right. That's the idea. And then you'd short companies and... more defensive sectors like utilities or consumer staples, which tend to be less affected by economic cycles.
- Speaker #0
Makes sense. Essentially, you're doubling down on that optimism cycle by focusing on those sectors that are most sensitive to it.
- Speaker #1
Precisely. And then as we move into the summer months, you'd reverse those positions, shorting the cyclicals and going long on the defensives.
- Speaker #0
So playing both sides of the seasonal trend.
- Speaker #1
Exactly. Now, it's important to remember that backtesting any of these strategies. Yeah. even those with solid research behind them, is crucial.
- Speaker #0
Absolutely. Yeah. Past performance is not indicative of future results. Right. But backtesting can at least give you an idea of how a strategy might have performed historically.
- Speaker #1
Right. And depending on the specific rules used and the time period analyzed, the results can vary quite a bit. Yeah. But several studies have shown that various forms of the sell-and-may strategy can, in fact, outperform a simple buy-and-hold approach. Uh-huh. at least during certain periods.
- Speaker #0
So it seems like there's some merit to this age-old saying.
- Speaker #1
Yeah.
- Speaker #0
But it's not a guaranteed path to riches.
- Speaker #1
Precisely. Yeah. And as we mentioned earlier, market efficiency tends to erode the profitability of these kinds of strategies over time.
- Speaker #0
Right. Because as more investors become aware of a pattern and try to exploit it, the advantage gradually disappears.
- Speaker #1
Exactly. So while historical backtests might look tempting. Right. You need to approach these strategies with a healthy dose of skepticism and consider how market dynamics might have changed.
- Speaker #0
It's a good reminder to always be adapting and evolving your strategies as the market landscape shifts.
- Speaker #1
Right. And that's why it's so important to understand the WHY behind a strategy, not just the what. If you understand the underlying reasons driving a pattern, you're better equipped to adapt when those reasons change.
- Speaker #0
Makes sense. So let's say someone is interested in trying out a sell-in-May strategy. Okay. What are some key things they should consider?
- Speaker #1
First and foremost. They need to honestly assess their own risk tolerance and investment goals. Market timing strategies like this inherently carry a certain level of risk.
- Speaker #0
Right. You're basically trying to predict short-term market movements, which is no easy feat.
- Speaker #1
That's right. It requires active management and a willingness to deviate from a more passive buy and hold approach. And as we discussed, thoroughly backtesting any specific rules you're considering is essential.
- Speaker #0
Absolutely.
- Speaker #1
Historical data can provide insights. Yeah. but it's not a crystal ball.
- Speaker #0
Right, and you always have to be prepared to adapt and adjust your strategy if it's not working anymore.
- Speaker #1
Absolutely, flexibility is key in the ever-changing world of trading.
- Speaker #0
Right, another crucial consideration is diversification.
- Speaker #1
Absolutely, don't put all your eggs in one basket.
- Speaker #0
Yeah, as they say.
- Speaker #1
Exactly, diversifying your portfolio helps mitigate risk and creates a more balanced and resilient investment approach.
- Speaker #0
Right, and of course, never forget about the costs. associated with trading. Oh, yeah. Those can really eat into your profits if you're not careful.
- Speaker #1
Transaction fees. Yeah. Slippage, taxes. Right. It all adds up. Yeah. So factor those costs into your back tests and calculations when evaluating the potential profitability of any strategy. Yeah. Including sell in May variations.
- Speaker #0
It seems like the sell in May strategy, while potentially intriguing, requires a lot of research planning and careful execution.
- Speaker #1
It's not a set and forget approach. Yeah. It's a tool that can be used effectively. Right. But it needs to be wielded with knowledge and Ausha.
- Speaker #0
All right. So we've explored the concept of the sell in May strategy. Right. Delved into the research behind it. Yeah. Discuss some potential trading rules and variations.
- Speaker #1
We've even touched upon backtesting considerations, the importance of risk management. Right. And adaptation.
- Speaker #0
But before we wrap up this deep dive, I want to circle back to a. key piece of evidence supporting the optimism cycle theory, the analysis of analyst earnings growth revisions. Right. Can you remind us what the researchers discovered about these revisions?
- Speaker #1
They found a clear seasonal pattern in how analysts revise their earnings growth estimates for companies. Right. As the end of the year approached. Yeah. Analysts tended to be much more optimistic, anticipating robust earnings growth in the coming year.
- Speaker #0
Almost as if they were getting swept up in the general wave of investor optimism.
- Speaker #1
Exactly. Yeah. But then as the year progressed and those rosy predictions were confronted with actual company performance. Right. Analysts had to revise their estimates downward.
- Speaker #0
So they were essentially chasing reality. Right. Just like investors might be chasing market trends.
- Speaker #1
That's a great analogy. Okay. And this pattern of downward revisions was most pronounced during the summer months, coinciding with a typical sell in May, period.
- Speaker #0
Interesting. So it wasn't just stock prices that were affected by this seasonal shift in sentiment. Right. Even the fundamental analysis of company earnings was influenced.
- Speaker #1
Precisely. This finding provides even more weight to the optimism cycle theory. It's not just about investors buying and selling based on their feelings. Those feelings actually permeate the very analysis of companies, shaping expectations and ultimately influencing market movements.
- Speaker #0
So the optimism cycle becomes this self-fulfilling prophecy in a way. Investors feel bullish. Analysts follow suit. Companies feel pressure to perform. And the market reacts accordingly, driving prices up.
- Speaker #1
Exactly. And then as reality sets in and expectations are adjusted, the cycle reverses, leading to the summer lull we've been discussing.
- Speaker #0
It's fascinating how these seemingly separate elements, investor psychology, analyst forecasts, company performance and market trends, all intertwine and create these complex patterns.
- Speaker #1
Right. It's a reminder that the market is not this perfectly rational machine driven solely by economic data, human emotions, biases. And even something as simple as the time of year can play a significant role in shaping market dynamics.
- Speaker #0
Absolutely. And those who are aware of these less than rational factors might be able to gain an edge.
- Speaker #1
Now let's dive a little deeper into the research on the U.S. market and the intriguing use of IPOs as a proxy for investor optimism.
- Speaker #0
Yeah, this is where things get really intriguing.
- Speaker #1
Remember how we talked about the researchers using the average initial return on IPOs as a gauge for investor optimism?
- Speaker #0
Yeah, IPOs was a clever way to quantify something like... Feeling bullish.
- Speaker #1
Exactly. And when they included this IPO return data in their U.S. market analysis, it almost completely explained the performance of their sector rotation strategy.
- Speaker #0
So they were able to isolate investor optimism as a major driver of those seasonal patterns, even after considering other market factors.
- Speaker #1
Precisely. It wasn't just a correlation. They actually quantified the impact of optimism. And remember, they specifically focused on initial IPO returns, not just the long-term performance of those companies.
- Speaker #0
Right, because those initial returns are thought to be heavily influenced by the hype and excitement surrounding those new offerings.
- Speaker #1
Exactly. It's like a pure measure of that initial wave of optimism that tends to accompany IPOs. And what they found was that these initial returns were significantly higher during the winter months, which aligns perfectly with that optimism cycle theory.
- Speaker #0
It paints a pretty clear picture. Investor optimism peaks in the winter, pushing up those initial IPO returns. And that sentiment spills over into the broader market, creating that sell-in-may effect.
- Speaker #1
That's the idea. It's a great example of how sentiment can ripple through the market and create opportunities, but also risks for those who are paying attention.
- Speaker #0
OK, so we've covered a lot of ground here, from the basics of the sell-in-may strategy to the research on the optimism cycle and the role of investor sentiment. What are your final takeaways for our listeners? What should they be thinking about as they consider this information?
- Speaker #1
Well, first and foremost, I think it highlights the importance of not dismissing age-old market sayings or patterns. There might be more to them than meets the eye.
- Speaker #0
Right, like the idea that there's actually some truth behind sell and may and go away.
- Speaker #1
Exactly. But it's crucial to dig deeper, understand the potential reasons behind those patterns, and then rigorously test any strategies based on them.
- Speaker #0
Because even if there is a genuine and market anomaly at play. It doesn't mean it's a guaranteed path to profit, right?
- Speaker #1
Absolutely. Market conditions change. Investors adapt. And what worked in the past might not work in the future. That's why continuous research, backtesting, and adaptation are so crucial for any trader.
- Speaker #0
So are you saying that listeners should consider incorporating a sell-in-may strategy into their trading?
- Speaker #1
I wouldn't go that far. It's not a one-size-fits-all solution. It's a tool. And like any tool, it needs to be used correctly and in the right context.
- Speaker #0
Meaning that it might make sense for some traders, but not for others.
- Speaker #1
Exactly. It depends on their individual risk tolerance, investment goals, and trading style. Someone who's uncomfortable with market timing or prefers a more passive approach might not find it suitable.
- Speaker #0
And as we discussed, even if you do decide to try it out, you need to be prepared to adapt and adjust your strategy as market conditions evolve.
- Speaker #1
Absolutely. That's key for any successful trader. The market is constantly changing and we need to change with it.
- Speaker #0
This has been a fascinating deep dive. I think our listeners have a lot to consider as they explore the sell in May strategy and the research behind it.
- Speaker #1
I agree. Hopefully they've gained some valuable insights that they can apply to their own trading journey.
- Speaker #0
Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktest.com. Happy trading.
