May 1, 2006
Short Sell The Dow in May?
By Brady Willett

$10,000 invested in the Dow Jones Industrial Average on Nov. 1 and sold on April 30 of every year would have netted the investor nearly $490,000 since 1950 (or a 7.9% average annual return). Conversely, $10,000 invested and sold May 1 to Oct. 31 would have produced a net loss of $502 during the same time.  As the markets enter May variants of these statistics, courtesy of the 2006 Stock Trader's Almanac, are being splashed across financial pages. And with the Dow trading near record highs the contrarian can not help but think that historical precedent is about to rear its ugly head.

“The Dow Jones Industrial Average may tumble as much as 30 percent between May and October from the six-year high set last month”. Bloom.  Jeff Hirsch, president of the Hirsch Organization

The problem with timing an investment based solely on market history is that history can take a vacation in any given year.  Such was the case last year when the Dow closed up by 2.1% from April-October but down on the year, and also in 2000 (Dow up 2.2% from A-O but down on the year).


But while 2005 and 2000 proved exceptions to the seasonal rule, context is key: in 2000 the Dow hit its yearly low in April and benefited from market rotation out of crashing technology stocks for the rest of the year. As for last year, the Dow went into freefall in April 2005 and closed at its lowest point for the year on April 28.  In other words, leading into May 2000 and May 2002 the Dow was ripe for a turnaround.  The exact opposite is true today.

What The Dow Bears Are Up Against


Although a slave to the general trend of equity prices, many have speculated that Dow companies are secretly purchased by the Fed to manipulate investor sentiment (and hence manage the equity price trends the Dow supposedly follows).  The evidence of such manipulation is spotty at best, and is usually summed up by nameless traders being baffled by mysterious and nameless buyers showing up in the market during times of stress.

Without straying into a PPT rant, it is safe to say that such theories are loosely grounded on events like those that took place early last week.  To be sure, with investor tensions rising along with the price of oil, the markets opened slightly lower last Monday. But then, suddenly, a powerful force entered the markets and certain Dow issues started to rally. The question is, why?
 

At first glance the onlooker could argue – so what, a few Dow components were up last Monday morning while most were down. However, remember that Dow components are
weighted by stock price, and that smaller increases in larger stock prices can easily mask widespread weakness in the average (i.e. with a 6.01% weighting a $1 increase in 3M could negate a $1 decline in Intel, Microsoft, and General Motors). With this in mind, was it a coincidence that the only companies rallying last Monday were Dow companies with the highest of weightings?

Suffice to say, not only are the Dow bears up against one of the slowest moving markets ever, record mutual fund inflows in 1Q06 (Lipper), a record string of 10+% earnings increases (S&P 500), and irrational investor reaction to the end of the Fed rate hike cycle, but they are also – potentially – up against the Fed.

What The Dow Bulls are Up Against

Surging oil, skyrocketing precious metals prices, rising commodity prices, a potential dollar crash, a potential housing market crash, record consumer debt, falling real wages, a slow down in earnings, etc.…take your pick from these and the ugliest of forecasts can be made. The kicker is that many measures of investor appetite for risk have never been stronger.

Along with the usual negatives, in the near term the bulls are also up against common (or contrarian) sense, which says prices do not continually move higher without a correction.  The last time the Dow lost more than 2% in a single trading session was on May 19, 2003 (-2.19%).  Given that since 1928 the Dow has declined by more than 2% approximately 3.09% of the time and that the Dow has not declined by 2+% over the last 603 trading session, history suggests that the Dow is overdue for a sharp decline.

Lastly, the bulls must contend with a Dow that is already up 6.1% this year and only a 3.5% rally away from reaching all-time highs. While it is true that psychologically important trading levels can turn into support levels if broken strongly to the upside, that mutual fund inflows have probably already peaked in 2006 could mean that the strongest gains for the market have come and gone.  Beyond favorable earnings trends, the best news for the bulls seems to be that the markets have not fallen to pieces in the face of so many potential threats.

"Five or six months of good markets give people increasing comfort and courage". Don Cassidy, a senior research analyst at Lipper. CBSM

Any Further Rally In The Dow Could Inflame Contrarian Spirits

Trading at nearly 20 times historical earnings and offering less than 2.5% in dividends, the Dow is overvalued based upon historical valuation averages. Moreover, if US interest rates continue to rise the ‘safe’ returns on bonds become even more attractive compared to the ‘risky’ returns from Dow components.  Quite frankly, faced with a slow down in the US economy bonds could quickly become a more favorable destination for capital than stocks. 

That said, the investment speculation to be made is not to blindly short the Dow because its May, but that if the Dow actually climbs to new record highs writing out of the money DJX calls, or shorting the index outright could gain speculative appeal.  After all, when the Fed stops raising interest rates – one of the misconstrued ‘positives’ bulls are braced for - this will be because something went bust in the US economy.

Picture it: A Dow at record highs with extreme valuations as something (i.e. housing) goes bust in the US economy.  Although badly beaten up since 2003, bears are not likely to ignore such an opportunity should it arise.


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