Is This the Year to Buy in May?

05/03/2012 5:00 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

With 2012 the final year of the presidential cycle, Tom Aspray points to historical patterns in election years that suggest this year could be one that will defy the old adage of “Sell in May and Go Away.”

Even though we have just begun the month of May, there has already been much discussion in the financial media about Wall Street’s most popular adage “Sell in May and go away,” and truthfully, many investors now regret not selling in May 2010 and 2011.

Of course, this old adage is based on the average monthly performance for the stock market, and a quick Google search will provide you with a large number of opinions about why you should or should not follow the advice in 2012.

Since this is the fourth year of President Obama’s term, there are some different historical forces at work. As Jim Stack points out in this recent interview, “There is only one presidential election year since 1940 that has seen a double-digit decline in the Dow, and that was 2008. Now on the flip side of the coin, if you look at how many presidential election years have seen double-digit gains since 1940, there have been seven of them. Those are the kind of odds that investors have to like this year.”

From a technical standpoint, it is the price action that tells me whether to get in or out of the market in any month or any year. Therefore, I wanted to look at the charts of the market during several different election years, starting with the historical charts for 1936, a year which some economists fear could be very similar to 2012.

In 1936, the economy stayed in recovery mode after the Depression, but then, in 1937, recessionary forces again took over. It eventually took World War II to turn the economy as well as the stock market around.

The historical charts of 1936 revealed some interesting similarities to 2012. The percentage change chart of the Dow Industrials shows the strong 10% rally in the first quarter, which peaked on April 10, 1936. The Dow then reversed sharply for three weeks and lost 6.7%.

chart
Click to Enlarge

By the second week of June, the Dow had started a new uptrend that carried higher until early 1937. From the May lows until the end of the year, the Dow was up 18.2%. In early 1937, the Dow added another 10%, but by October 1937, it was below the May 1936 lows.

So what did some of the modern technical tools tell us about the market during this period? Though it had not been invented yet, one of my favorite technical tools, the on-balance volume (OBV) indicator, which was developed by Joe Granville, gave some very interesting signals.

(It should be noted that ever since the OBV became available in computer software over 30 years ago, my methods of analyzing the OBV have differed from Mr. Granville’s.)

Article Continues on Page 2…

|pagebreak|

For more than a year, the OBV had been locked in a trading range that was resolved in May 1935 (line 1) when resistance at line b was overcome. The increase in volume was clearly evident.

The OBV stayed above its weighted moving average (WMA) until December 1935 and only dropped below it for two weeks. By early 1936, the OBV was again above its rising weighted moving average. Even though the volume was relatively low during the correction, the OBV stayed below its weighted moving average until June.

chart
Click to Enlarge

The Dow Industrials were strong during the fall months as Franklin D. Roosevelt was re-elected in a landslide victory, winning 46 out of 48 states. The 20-month uptrend in the OBV, line c, was briefly broken in December 1936, but the OBV surged again in early 1937.

At the February 1937 highs, the OBV formed a slight negative divergence, line d, and by April (line 2), the OBV had topped out. Though the overall volume was lighter in 1937, the OBV formed a pattern of lower lows.

The next year that looked interesting was 1944 when Roosevelt defeated the former Governor of New York Thomas E. Dewey. Stocks dropped in early 1944 as the Dow was down about 2% in January and after a mid-March rally the market again weakened.

chart
Click to Enlarge

The Dow Industrials were back in the red by the end of April, but stocks turned higher in early May when the Dow moved back into positive territory. By the end of the month, the Dow was in a clear uptrend, and from the May lows to the end of the year, the Dow had gained 11.5%.

The weekly bar chart (see below) shows that the OBV broke through three-year resistance, line a, in late 1942 (line 1). This confirmed the new uptrend in the Dow Industrials, which had bottomed at 92.92 in May 1942.

chart
Click to Enlarge

The Dow Industrials formed a flag formation, lines b and c, from May 1943 through May 1944. On April 29, the Dow Industrials made a low of 135, but four weeks later, the index completed its flag formation by closing above resistance at line b. The Fibonacci retracement target from the formation at 150.50 was hit by the middle of July.

The completion of the flag formation was confirmed by the OBV when it overcame its resistance, line d, as volume increased significantly. The OBV stayed in a solid uptrend (line e) well into 1945 and started to rise very sharply in early 1945. The Dow finished the year on a strong note, gaining just over 12% for the year.

NEXT: Important Similarities from the 1952 Election

|pagebreak|

The election in 1952 took place when the Cold War between the US and Russia was just heating up. It was won by General Dwight D. Eisenhower, who was the first Republican President elected since 1928. For those of you who follow the Chinese zodiac calendar, that was also the last year of the Water Dragon prior to 2012.

In January 1952, the Dow managed a meager gain of 1%, but by the middle of February, it was down 4%. The Dow tried to rally in March but again traded near the lows in both April and early May. It was not until June that the Dow moved back into positive territory, peaking in the middle of August up 3% for the year.

chart
Click to Enlarge

By the end of October, it was back in negative territory but then rallied for the rest of the year, closing with a yearly gain of close to 8%. From the May lows, the gain was closer to 12%, which was a fairly respectable performance.

From the bar chart below, the Dow’s performance in 1952 is seen in a much different context. In early-October 1949 (line 1), the Dow Industrials broke through three-year resistance, line a, in the 180 area. The volume increased on the breakout and was the highest of the past year, line b. The OBV had already bottomed and was above its rising weighted moving average.

chart
Click to Enlarge

The Dow Industrials were in a strong uptrend for the next two years and by the end of 1951, the Dow was up almost 50% from the breakout level in 1949. Connecting the 1949 and 1950 lows, the uptrend, line c, identified good support.

From the September 1951 highs, the Dow started an eight-month trading range. The lower boundary of this flag formation, lines f and g, was tested in early-May 1952 when the Dow dropped to a low of 256.35.

While the flag was being formed, the OBV stayed in a narrow range with an upward bias, line e. The OBV stayed well above long-term support, line d, that went back to the 1949 and 1950 lows.

The flag formation was completed in early July and stocks rallied into the middle of August. The correction from the highs was sharp enough to break the long-term uptrend, line c, but the Dow held well above the May 3 lows.

The volume bars reveal that the selling on this decline was not heavy. From the October lows, the Dow rallied to close on the highs, finishing the year with a gain of over 11%.

NEXT: The Pivotal 1980 Election Year Revisited

|pagebreak|

The last election year we’ll look at is 1980, which most of us remember as a pivotal year for the markets and the economy. It was also a wild year for the Dow Industrials, and after gaining almost 12% in the first five weeks of the year, the market underwent a sharp correction.

By late March, the Dow Industrials were down over 5% for the year and retested the lows in the latter part of April before turning higher. By May 16, the Dow Industrials had moved back into positive territory, finishing the year with a near-32% gain. Of course, measured from the April lows, the gain was closer to 37%.

chart
Click to Enlarge

The below daily chart of the Dow Industrials shows the spike low on March 27, 1980 and then the retest of the closing low on April 23. By early May, the OBV had broken its downtrend, line a, and was in a clear uptrend by the end of the month. The rally in the Dow was relentless until early August when it started to develop a trading range.

chart
Click to Enlarge

For the rest of 1980, the Dow traded in about a 100-point range and dropped to test the 38.2% Fibonacci retracement support at 900 in December before surging into the end of the year. The daily OBV moved above and below its weighted moving average during this period and briefly violated its uptrend (line c) in December. The OBV did make new highs at the end of the year, confirming the price action (line d).

So what does this mean for 2012? The percentage change chart (left panel below) shows that the Dow is currently up over 8% for the year. It would take a decline below 12,217 to move it back into negative yearly territory.

chart
Click to Enlarge

The weekly chart of the Dow Industrials (right panel below) shows that it made a new high on May 1, line a, but as we go to press (Thursday, May 3), it is down a bit for the week. The weekly OBV has not yet confirmed the new highs, as it currently shows a lower high, line c.

The OBV is still above its weighted moving average, and the key support level to watch is at line d. A break below this level could confirm the negative divergence. There is weekly support now at 12,710, line b.

As I have been pointing out for the past few weeks, the daily Advance/Decline (A/D) lines for the major averages are deteriorating, which is consistent with a market correction. They do not yet show patterns consistent with an intermediate-term top, however.

The weekly analysis is always the most important, and by the end of this month, we should have a better idea of whether a significant top has been formed or whether it is just a normal correction. In either case, it is always important to have stops in place and to carefully control risk on any new positions.

Related Articles on STRATEGIES