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The Secret of the Annual Switching Strategy

Written By Briton Ryle

Posted November 4, 2014

You’ve likely heard the mantra, “Sell in May and go away”, warning investors to lock in profits and hunker down for the annual summertime pullback in stocks.

But “go away” until when? When are investors supposed to come back? According to the Stock Trader’s Almanac, the time for investors to get back in is now!

November is the “start of the best six months of the year”, the Almanac proclaims. “Investing in the Dow Jones Industrial Average between November 1st and April 30th each year and then switching into fixed income for the other six months has produced reliable returns with reduced risk since 1950,” it adds.

This has been a long-known and oft-used investment strategy that even experienced professional money managers will attest to. But while the strategy works “generally” over the longer term, does it still apply during these unprecedented times of central bank stimuli in America and the rest of the world? Might we be going through a period when this tried and tested annual switching strategy simply loses its potency?

I’ve run a simple table of my own using data from the last ten years that may shed some light on the effectiveness of the switching strategy even during our current unique economic environment.

First, let’s take a look at what the annual switching strategy is all about.

The Annual Switching Strategy

The premise underlying the annual switching strategy is simple: stock markets tend to rise during the winter and spring, and fall during the summer and autumn.

According to the Stock Trader’s Almanac, November, December, January, March, April and July are the best performing months of the year, averaging gains of +1.5%, +1.7%, +1.1%, +1.2%, +1.5% and +1.0% respectively on the S&P 500 index from 1950 to 2014.

In contrast, the worst six months of the year are February, May, June, August, September and October, averaging changes of -0.03%, +0.2%, -0.03%, -0.06%, -0.5% and +0.8% respectively.

These would form perfect blocks of 6 months each were it not for two anomalies: bearish February is stuck in the middle of a herd of bulls, while bullish July and slightly bullish October are stuck amidst a sloth of bears. For the sake of convenience, then, the switching strategy simply overlooks the misplacement of February, July and October, and runs with the majority.

When added all together, the six months from November to April total +6.97% worth of change, while the six months from May to October total +1.41%. That doesn’t seem like much of a difference, does it? Just 5.56% between the two halves. But over several years and decades, you’d be surprised at how it all adds up.

So how do we employ the switching strategy? We have three general versions to choose from:

• The moderate version dictates holding the more bullish discretionary stocks for the generally bullish six months from November 1st to April 30th, and then switching to the more defensive staple stocks for the generally bearish six months from May 1st to October 31st. Hence the “sell in May” rule.

• A more conservative switching strategy uses money-market funds instead of staples during the bearish months, or perhaps the more stable bond funds that pay a decent dividend yield.

• A more aggressive switching strategy would actually short the broader market during the bearish months. While this can greatly multiply your profits when the year follows the pattern perfectly, there are years when the pattern does not hold up as expected. Being caught short during one of those trend-bucking years when the market actually rises during the summer and autumn can be very costly. So I wouldn’t recommend shorting.

For the purpose of today’s calculations, I’ve decided to go with the more moderate of the three versions of the switching strategy – switching from discretionary to staples and then back again. My funds of choice are the SPDR Consumer Discretionary ETF (NYSE: XLY) and the SPDR Consumer Staples ETF (NYSE: XLP).

So let’s have at it. What do the figures reveal?

Switching On the Switching Switch

Since my table goes back only 10 years, let’s first look at what the Trader’s Almanac generated, since it goes all the way back to 1950.

In the 64 years tabulated, in all six-month blocks from November to April added together, the Dow Jones index rose an incredible 17,432 net points, while falling 1,066 net points during all the bearish six months from May to October. For its part, the S&P index gained 1,790 points during the bullish halves, while gaining only 75 points during the bearish halves.

According to the Almanac’s tabulations, a $10,000 investment in 1950 held in the Dow Jones index only during the bullish half of each year would have gained $816,894 by April of 2013, while a similar investment held in the index only during the bearish half of each year would have lost $678 by October of 2013.

What would an investor have had to do to capture that $800K profit? Simply switch into the index every November 1st and switch into a money-market fund every May 1st. Just two easy trades per year.

But would the strategy hold up even during periods of central bank intervention? We all know that Quantitative Easing measures and all-time low interest rates have skewed the markets’ behavior. Might the switching strategy fail us through these easy money policy years?

Not at all. The system still holds up nicely, as my table below shows, spanning the last 10 years from November 1st, 2004 to October 31st, 2014. Through a market bubble and its burst, through a market implosion and its recovery, the switching strategy lives on in all its glory.

switching strategy chart one

Without using any switching strategy at all, an investor holding the S&P index from November 2004 until October 2014 would have gained net changes of +74.5%, while an investor holding just the Discretionary fund XLY would have gained +89.75%, and an investor holding just the Staples fund XLP would have gained +82.5%.

(It is important to note, however, that these aren’t the changes straight through the last 10 years, but are the adding together of each 6-month block change for the sake of keeping the comparisons accurate.)

Yet if an investor had used the moderate switching strategy of holding the Discretionary XLY during the winter and spring and holding the Staples XLP during the summer and autumn, they would have gained +111.5% over the 10 years (labelled “Pro-Rule”).

Conversely, if the investor had gone the opposite way, holding XLP during the bullish half and the XLY during the bearish half, they would have gained just +60.75% (labelled “Contra-Rule”).

Staples Better Than Cash

Yet investors need to note that not all years will behave according to the pattern. For example, in my table above, each 6-month block in which the switching strategy worked is shaded green, while each block in which the strategy didn’t work is shaded yellow.

Over the past 10 years, or 20 six-month trading blocks, in only 12 blocks, or 60% of the time, did the markets perform according to the pattern. During 8 blocks, or 40% of the time, the pattern did not hold.

Even so, using a staples fund like XLP would still be better than switching into cash or a money market fund during those bearish 6-month blocks, as noted in the table below.

switching strategy chart two

Where switching between the discretionary XLY and the staple XLP would have gained 111.5% in summed changes, switching between XLY and cash would have gained only 80.5%.

Why is the staple XLP better than cash during the bearish months? Simply put, because those bearish 6-month blocks are not always bearish. Sometimes the market rises all year round; just look at all the positive XLP data in the bearish “mid” year cells in the table above. The staple XLP would have gained you as much as 10%, 15.5%, or even 17% during some bearish 6-month blocks as noted above – gains which would have been missed if you were sitting in cash or money-market funds during those periods.

True, cash would have spared you during those bearish months when the XLP lost. But over all and over the longer term, it pays to be in the market all year round. As we’ve seen here, switching just two times a year at key times could pay you all the more. And now is just the time to be switching toward the bullish side.

(As a note for clarity, generating a graph of the S&P, XLY or XLP over the past 10 years will produce much higher percentage returns than you see totalled along the bottom of the tables above. This is due to the 10-year graph showing total percent change as compared to the value 10 years ago. The tables above, in contrast, break each 6-month block individually, noting the percent change over each 6-month period, and then adding up each 6-month change, producing a lower number than a 10-year graph would – given that each individual 6-month block starts at a different level [generally higher] than the 10-year graph’s starting level. But for the sake of comparing multiple switching strategies, the summation of 6-month blocks conveys the correct difference from one strategy to another.)

Joseph Cafariello