Summer has a reputation for ushering in a corrective phase in the northern hemisphere equity markets. Yet deciding to “Sell in May and go away” could prove unwise this summer, particularly in light of the stock market rally that began in March.

Don Coxe, chairman of Chicago-based Coxe Advisors LLC, and the 2008 recipient of the National Post/StarMine lifetime achievement award for excellence in investment research, has strong views on the subject. “I’m not denying the wisdom in these seasonal observations, but this is a continuum,” he says. “Remember, we were in what amounted to a continuous bull market from 1982 to 2000, and then we had a nice bull market that started in 2002 and lasted until a year ago.”

When designing an investment portfolio, one of the most important objectives is to manage risk, or volatility. You can sidestep volatility by only holding low-risk investments, but then you must be prepared to accept the low returns – and shortfall risk – that come with the territory.

There must be a better way, and there is. Diversification is the widely understood notion of holding several kinds of investments to spread out your risk. When diversification works at its best, you can significantly reduce volatility without sacrificing much in the way of long-term returns.

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Great news! We’ve enhanced our Refer a Friend program to give you double the AIR MILES®^† reward miles. Now, tell your friends about how rewarding online investing with BMO InvestorLine can be and you’ll earn 250 AIR MILES reward miles for each friend that qualifies. Plus if you’re a 5 Star Client, you’ll receive an extra 100 AIR MILES reward miles.

What’s more, your friends will receive 250 AIR MILES reward miles as well.

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Looking for investments that are easy to understand and offer trading flexibility at a low cost? Consider ETFs. BMO Financial Group has launched a series of 4 BMO ETFs that cover most of the major North American asset classes. These include:

• BMO Canadian Government Bond Index ETF
• BMO Dow Jones Canada Titans 60 Index ETF
• BMO U.S. Equity Index ETF
• BMO Dow Jones Diamonds Index ETF

In December 2008, BMO Financial Group became the first and only major Canadian bank to offer registered disability savings plans. This plan helps parents and others save for the long-term financial security of a person with severe or prolonged disabilities.

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Summer has a reputation for ushering in a corrective phase in the northern hemisphere equity markets. Yet deciding to “Sell in May and go away” could prove unwise this summer, particularly in light of the stock market rally that began in March.

Don Coxe, chairman of Chicago-based Coxe Advisors LLC, and the 2008 recipient of the National Post/StarMine lifetime achievement award for excellence in investment research, has strong views on the subject. “I’m not denying the wisdom in these seasonal observations, but this is a continuum,” he says. “Remember, we were in what amounted to a continuous bull market from 1982 to 2000, and then we had a nice bull market that started in 2002 and lasted until a year ago.”

He adds, “We’ve been through a mammoth bear market that occurred in an extremely short time, accompanied by a massive inventory reduction. I was speaking in Toronto [in early June] to some people in the specialty steel industry who supply the oil service industry. They believe the inventories in that industry – which averaged about six months [of supply] over the years – are now down to a matter of days. You don’t even think of selling at a time like this. In this case, we have some extraordinarily favourable factors for equity investing.”

These include the market rally since March 9 that saw a 35 percent jump in the S&P/TSX composite index, to 10,547 on June 9. Slowing job losses and a five-month steady climb in the U.S. ISM manufacturing index, a leading indicator, are just a few of the signs pointing to an easing of recessionary conditions. Yet many market watchers believe the remaining negative economic influences, such as slow growth, the collapse of the housing bubble and enormous government deficits, will sabotage recovery and prompt a pullback. Ben Joyce, an equity portfolio strategist with BMO Capital Markets, says, “You could make a good case that the markets have made an enormous leap since March 9 and are due for a correction.”

Worried that the three-month rally may have run its course, investors are scanning the horizon for signs of significant retrenchment in share prices. In the search for guidance, it’s tempting to factor in the old saying “Sell in May and go away.” A recent online search turned up 37.2 million websites and blogs that referenced the phrase, second only to “Buy low, sell high” in terms of popular investment adages.

Joyce cites the bigger economic picture as a factor that should carry more weight in the investment decision-making equation. An analysis of where we are in the business cycle – are we headed for a recession or a recovery? – overrides the issue of seasonality, “which still looks like small potatoes compared to the call on where the cycle is headed.”

The rebirth of investor confidence and upticks in market psychology are also overshadowing “anything one would cite as a seasonal factor from past data,” he says. The pendulum has swung from risk tolerance last summer to extreme risk aversion during the fall and spring, followed by a gradual return to risk tolerance. With caution still reining in stock valuations, there’s room for upward movement in profit projections and economic prospects, Joyce believes. “All of this dwarfs the question of ‘sell in May and go away,’” he says. “We think a new bull market is under way. Valuations are still relatively attractive, and we expect stocks to perform absolutely and relatively well over the next year.

“The markets hit bottom on March 9 with the depression scare. We don’t expect to see that kind of negative psychology build up again. That doesn’t mean the market cannot correct after it has gained, but we have a one-year S&P/TSX target of 10,750, and 975 for the S&P 500. We wouldn’t get defensive until we at least go through those targets.” In his view, “Economic recovery is coming later this year, and stock prices anticipate that within eight to 12 months, depending on the market. We just had the best turn ever. Whether you see the glass as half full or half empty, some people are a little alarmed at how quickly we’re moving along. When we look at the overall market valuation, we’re still confident that we haven’t overdone it. Even after this jump, stocks have relatively good attractiveness against bonds or cash, so we are keeping the green light on.”

Regarding seasonal portfolio adjustments, Coxe says, “There are some things that are going to override the sheer seasonal factors this year.” He points to the volume of positive signs globally that indicate we’re emerging from a deep recession. “This is not a time to be selling. There’s a lot of liquidity out there. If the dam breaks, it could bury a lot of evidence of past crimes,” he says. “Similarly, when you have this kind of liquidity flowing, it can cover up many of the events that have scared people. I’m increasing equity exposure – not a huge amount – for the first time in a year and a half.”

To investors who may be pondering a seasonal retreat until the cooler months, he says, “I’m not asking for the rules to be repealed, but investors should remain cautious about applying them in such an exceptional time.” Joyce concurs, adding, “Seasonality is not a reason to sell.” He offers this advice to individual investors: “If you’re already in, then stick with it.” If you’re still on the sidelines, he believes it’s not too late to raise your equity exposure within a diversified portfolio. As for the maxim “Sell in May and go away,” Joyce concludes, “It’s just not valid.”

All market forecasts and opinions illustrated in this article are provided by a third party. The opinions and views expressed in the following article are that of the author and not necessarily BMO InvestorLine. This article has been reprinted for the InSite Newsletter and should be used as a general source of information. It is not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard.

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When designing an investment portfolio, one of the most important objectives is to manage risk, or volatility. You can sidestep volatility by only holding low-risk investments, but then you must be prepared to accept the low returns – and shortfall risk – that come with the territory.

There must be a better way, and there is. Diversification is the widely understood notion of holding several kinds of investments to spread out your risk. When diversification works at its best, you can significantly reduce volatility without sacrificing much in the way of long-term returns.

However, diversification will not do its job if you combine investments that tend to go up and down at the same time. It works best when you deliberately seek out and match investments that typically go up and down at opposite times. When you apply this concept to your investment portfolio, you’re using a principle called correlation.

Match asset classes with offsetting performance cycles
Correlation is the science of analyzing historical market data to determine performance cycles for various asset classes, and then matching asset classes with offsetting cycles. For example, if you own a balanced or asset allocation mutual fund, the portfolio manager will almost certainly pay attention to correlation. It’s part of the expertise you’re paying for in your management fee.

How is correlation measured? The results of a long-term, head-to-head comparison of two asset classes are plotted on a scale ranging from minus one (–1) to plus one (+1), with zero (0) as a midpoint. Two asset classes with completely opposing performance cycles (most desirable) would score a –1. Two asset classes with identical performance cycles (least desirable) would score a +1. Correlation scores at these extremes are rare, so most comparisons plot somewhere in the middle. Asset class comparisons scoring between 0 and 1 are “positively correlated,” while those between 0 and –1 are “negatively correlated.”

Use correlation together with other approaches
Once you know the correlation scores of various asset class comparisons, you might think the logical next step would be to build a portfolio of the most negatively correlated assets you can find. But it’s not that simple. Correlation should be used along with other portfolio construction strategies, such as asset allocation and security selection. There is no point in adding an asset with the right correlation properties if it makes little sense from an investment standpoint. For example, some emerging market bonds may have a negative correlation with Canadian equities, but low credit quality and/or performance can make them poor choices as investment holdings.

Nevertheless, correlation has been used successfully for decades. One example is the classic balanced portfolio of stocks and bonds. When the stock market drops, bonds usually rise or retain more of their value than equities. If you compare the 10-year performance of the median Canadian balanced mutual fund with the median Canadian equity mutual fund, you’ll find that balanced fund investors have sacrificed just a few points of performance to experience much lower volatility over time.

A more current example of correlation is found in gold, which was described in one recent newspaper article as “the only asset class to do its job [in 2008].” That performance was due in part to the fact that gold is negatively correlated to almost every other asset class, including other commodities. Because our current economic crisis grew from a credit crisis, typically resilient debt investments suffered with equities and real estate in the downturn of Q4 2008 and Q1 2009. Many investors fled to the safety of gold, causing its price to soar above US$1,000 per ounce.

Correlation works just as well for income-generating portfolios
While correlation is often associated with portfolios that accumulate assets, investment managers are finding that it works equally well for portfolios that generate income. Persistent low interest rates and the decline of guaranteed pensions are pushing alternative income-producing investments – such as dividend-paying equities, high-yield bonds, income trusts and commercial mortgage-backed securities – to the forefront. These asset classes also have varying degrees of correlation to one another, letting investment managers diversify to supply reliable income in higher amounts with no need for a guarantee.

A well-designed portfolio does manage risk, but not necessarily by avoiding higher-risk investments. Instead, by using the principle of correlation, a well-designed portfolio counter-cycles various asset classes to moderate volatility while maintaining high returns.

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We’ve recently enhanced MyLink® to bring you more timely, personalized information about your portfolio holdings, so you can make better investing decisions. New updates include:

• Analyst Rating Changes
  Receive personalized analyst rating changes, based on your equity holdings, directly to your secure inbox. We’ll alert you to changes in third-party recommendations, ratings and target prices for Canadian and U.S. stocks. In addition to receiving analyst rating changes specific to the stocks you hold, you can also customize those that you’d like to receive. Simply update your Communication Preferences in your Account Profile.
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  Receive corporate action notifications, such as mergers, stock splits and shareholder notices, directly to your secure inbox. To learn more about corporate actions, visit our Frequently Asked Questions section.

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Great news! We’ve enhanced our Refer a Friend program to give you double the AIR MILES®^† reward miles. Now, tell your friends about how rewarding online investing with BMO InvestorLine can be and you’ll earn 250 AIR MILES reward miles for each friend that qualifies. Plus if you’re a 5 Star Client, you’ll receive an extra 100 AIR MILES reward miles.

What’s more, your friends will receive 250 AIR MILES reward miles as well.

Learn more

Back

Looking for investments that are easy to understand and offer trading flexibility at a low cost? Consider BMO ETFs. BMO Financial Group has launched a series of 4 BMO ETFs that cover most of the major North American asset classes. These include:

• BMO Canadian Government Bond Index ETF
• BMO Dow Jones Canada Titans 60 Index ETF
• BMO U.S. Equity Index ETF
• BMO Dow Jones Diamonds Index ETF

Learn more

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In December 2008, BMO Financial Group became the first and only major Canadian bank to offer registered disability savings plans. This plan helps parents and others save for the long-term financial security of a person with severe or prolonged disabilities.

• Anyone can contribute to an RDSP
• The lifetime contribution limit is $200,000 per beneficiary, with no annual limit
• Contributions may qualify for payments from the Canada Disability Savings Grant (CDSG)* program, up to a lifetime maximum of $70,000 per beneficiary
• Lower-income beneficiaries and families may qualify for payments from the Canada Disability Savings Bond (CDSB)* program, up to a lifetime maximum of $20,000, without having to contribute to an RDSP
• Growth on investments within the plan is tax deferred
• When funds are withdrawn, the CDSG, CDSB and any investment income are taxed to the beneficiary, who likely has a much lower tax rate than parents or other contributors

* Eligibility ends December 31st in the year the beneficiary turns 49. Both the CDSG and the CDSB are contributed by the Government of Canada and paid directly to the plan on behalf of the beneficiary.

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A survey of Canadian households shows that investors have only 13% of their total wealth in non-Canadian holdings.* Conversely, many large pension plans are allocating more to their portfolios’ global content. For example, the Canada Pension Plan’s global equity portion has grown to 35%, according to the The Globe and Mail (Feb. 26, 2007). You decide how much global content may be right for you, to help you capitalize on opportunities and reach your investment objectives.

*Source: Investor Economics, Household Balance Sheet Report, 2007 edition

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