Sell in May and the London whale

I was in a great debate with a mathematician who builds algorithms for a multibillion-dollar hedge fund. He was adamant that his market timing and stock picking algorithms did better than just owning market index funds like ETFs, consistently, over a long period.

But he was often stumped when discussing his performance in 2008 (his math didn’t predict when to get out and back in) and in 2011, he was wrong about timing in August.

Finally, he said: “If there is one market timing strategy that works, it is ‘sell in May and go away’! I’ve backtested this for years and years and it has shown to increase returns.”

This “tried and true” trader’s adage advises that one sell everything going into the summer and buy back in after Labor Day has certainly worked the last couple of years. The U.S. market peaked in April 2010 and then dropped until the Fed agreed to flood more capital into the economy with QE2. In 2011, after peaking in April, the U.S. market fell from July into October while our government dealt with the debt ceiling and panic erupted over European financial contagion over Greece.

On April 2, 2012, the S&P 500 (^GSPC) closed at 1,419 and has reversed course down to about 1,330 today, already down over 6%. Is it time to sell in May? It depends upon what your goals are as an investor.

The problem with market timing is that like most successful trading strategies, it works, until it doesn’t. And when it stops working, the losses can be dramatic. Just ask the now infamous “London Whale,” at JP Morgan Chase (JPM).

Traders affectionately call this “blowing up” — when a trade works and then suddenly, doesn’t. In “Blowing Up” (April 2002, New Yorker Magazine), Malcolm Gladwell recounts a story told by famous options trader Nassim Taleb:

“A year after Nassim Taleb came to visit him, Victor Niederhoffer blew up. He sold a very large number of options on the S&P index, taking millions of dollars from other traders in exchange for promising to buy a basket of stocks from them at current prices, if the market ever fell. It was an unhedged bet, or what was called on Wall Street a “naked put,” meaning that he bet everyone on one outcome: he bet in favor of the large probability of making a small amount of money, and against the small probability of losing a large amount of money—and he lost. On October 27, 1997, the market plummeted 8%, and all of the many, many people who had bought those options from Niederhoffer came calling all at once, demanding that he buy back their stocks at precrash prices. He ran through a $130 million—his cash reserves, his savings, his other stocks—and when his broker came and asked for still more he didn’t have it. In a day, one of the most successful hedge funds in America was wiped out. Niederhoffer had to shut down his firm. He had to mortgage his house. He had to borrow money from his children. He had to call Sotheby’s and sell his prized silver collection—the massive 19th-century Brazilian “sculptural group of victory” made for the Visconde De Figueirdeo, the massive silver bowl designed in 1887 by Tiffany & Company for the James Gordon Bennet Cup yacht race, and on and on. He stayed away from the auction. He couldn’t bear to watch.”

Here are a few more reasons why you probably shouldn’t try your hand at market timing:

1. Getting out on time is the first trick. Getting back into the market is just as important. If you get out a little late, and in a little early, you may end up worse than doing nothing.

2. For retirement investors, owning a diverse set of asset classes is important. In the last 12 months, the S&P 500 hasn’t changed that much, but the Vanguard Emerging Markets ETF (VWO) is down nearly 20%. Are you able to time multiple markets, not just the U.S.’s?

3. In a taxable account, the difference in tax rates can consume much of the advantages of your trade. You have to make 35% more in short-term gains just to break even with long-term gains on an after-tax basis.

If you learn how to rebalance your portfolio, you can capture many of the gains from market volatility without betting on the market’s direction. But if you find investing ‘fun’ then this blood sport is one of the best on the planet. If you are working hard as the steward of your retirement funds, then play the game at your own peril.