Ok, the market has rendered its verdict.  The maxim “Sell in May” has turned out to be a viable one. 

The charts tell me that stocks are oversold and due for a bounce.  That’s not wishful thinking on my part.  I’m not a bull or a bear — just a trader and a technician.  From what I see, it appears that the recent avalanche of selling has occurred so quickly that it would not surprise me to see stocks attempt to rally.

Now, that doesn’t mean you should ignore the short-term carnage that has been taking place.  To the contrary, I think the drop in equities over the last week-and-a-half is significant.  But just how significant is it?  And what does it suggest for stocks in the near-term?

To get a sense of what declining prices in May means in historical terms — and what a sell-off in May suggests for the future, I consulted the S&P 500’s historical prices from 1970-2005 to search for some possible answers.

The first thing I wanted to find out was how the current drop in the S&P 500 stacks up against prior May sell-offs.  Before I go further, I should note that the S&P 500 has suffered a 5.6% decline from its intra-day high of 1326.70 on May 8 to yesterday’s low of 1252.98.   

I evaluated each of the previous thirty-six years in the S&P 500 on the basis of the distance the index fell from the high set in the first four months of the year to the subsequent low registered during the month of May.  The only exceptions I made were for the years 1983 and 1999.  Those two years were similar to 2006 in that, in both years, the S&P 500 notched new highs in May before subsequently putting in a low in the latter part of the month.

So, just how common is a 5.6% decline in the S&P 500 from a calendar year high to a May low?  According to the index’s trading history going back to 1970, a setback of that magnitude or greater is very common indeed.  In fact, what is not very common is to see a May low less than 5.6%.

In the thirty-six years I studied, the S&P 500 suffered a pull back to a May low in excess of 5.6% thirty-one times. That’s better than six out of every seven years!  Moreover, the average decline in the S&P 500 from 1970-2005 from a calendar year high to a subsequent May low was 8.6%.  In other words, the sell-off we have seen so far is rather mild by the S&P 500’s historical standards. 

However, the key question to try to answer at this point is, what can we expect next?  Now, I’m not suggesting that we’ve seen the lows for May.  My purpose in writing this article is to see if we can get a heads up on what the future might hold by taking a look into the past.  Let me just say that — whether we’ve seen the lows for May or not — the present trend is bearish.  And although I expect the market to attempt to rally from the recent sell-off, I don’t believe we’ve seen the lows for 2006. 

Nevertheless, to see if my expectation of a further decline has a basis in recent market history, I did some additional searching through the S&P 500’s historical data.  What I found only confirmed my suspicions — and what I think the current chart patterns are telling us.  Let me share some numbers with you.

Between 1970 and 2005, the S&P 500 violated its May bottom in a subsequent month on twenty-three occasions — or 63.9% of the time.  Thus, the chances are favorable that — whether we have already seen May’s lows or not — even lower prices await us sometime between now and the end of the year.

That’s not all.  If the S&P 500 has already marked its low for May, the odds of seeing a lower low sometime between June and December becomes infinitely greater. 

On eleven of the thirteen occasions where the S&P 500’s May low marked the low for the remainder of the calendar year (including 2003 and 2005), — the index had already suffered through a decline greater than the 5.6% we’ve witnessed so far.  Only in 1993 and 1995 did the index post a modest decline into its May low and then turn up for the rest of the year.

What this means is that — despite the seeming severity of the recent drop in stock prices — the worst is yet to come.  Whether or not we have seen May’s lows, according to the S&P 500’s historical trading pattern, odds favor still lower lows for the index.

What does that mean for you?  If you are a trader and hold several positions, you may want consider lightening up.  Given the swift, sharp nature of the recent plunge, we have quickly reached an oversold condition in the market.  You might want to consider using a recovery rally as an opportunity to close out — or cut back — on some of your long positions.

If you are an investor with a long-term timeframe, you might not be as concerned with the latest setback in stock prices.  After all, according to trading patterns going back to the 1970s, the decline we have witnessed to date has been a rather modest one.  So, the recent turbulence may not concern you a great deal.

Nonetheless, based on the historical data I have cited, you might want to use a near-term rally to consider lightening up a little on your holdings — or making some minor adjustments to your portfolio.  If the action of the last few decades is any guide to what lies ahead, we’re likely to see lower prices some time later this year.  And if that turns out to be the case, odds are good that you’ll be able to repurchase some of your favorite stocks at even lower prices.

History doesn’t always repeat itself in the same way.  But patterns do have a tendency to recur.  That’s one of the reasons technical analysis can be useful to your trading or investing efforts.

Trade well,

Mark Bail
May 23, 2006

What Can We Expect Next? was originally featured in the Penny Sleuth.