Sell in May? The Yen Carry Trade Sends a Warning

After having one of the worst starts in market history, equities bounced back in a big way, posting positive returns and overcoming a dreaded 10% correction. However, since the remarkable return, equities have run in to the proverbial wall as the calendar turned the page on April and set its sights on May and beyond, a period that is notorious for producing lower equity returns. But will "Sell in May and Go Away (to the Hamptons)" hold true to form in 2016 or are fears of a market slow down or worse warranted?

The Warning Signs

During bullish periods, traders often times will employ a trading technique called the "carry trade" where a trader sells one security with low yields and uses the proceeds to purchase higher yielding securities. Oftentimes the securities used are the Japanese Yen and the U.S. dollar. When the technique is being widely employed the Yen usually weakens, which is one desired outcome of the trade. The trade is completed when the Yen is repurchased with the sale of the higher yielding (hopefully) securities. The difference is the trader's profit. Therefore, a weak Yen is often viewed as confirmation of a bullish market trend. However, what happens when the reverse is true? Since the beginning of the year, the Yen has strengthened 12% against the U.S. dollar, initially confirming early weakness in equities. However, when equity markets rallied, the Yen did not confirm the bullishness and continued to climb. Was the Yen sending a signal about the strength and durability of the equity rally? It may or may not be, but recent equity weakness in the face of the seasonally weak period does not typically bode well for equity performance this summer.

It's About Earnings (and Fundamentals)

Seasonality and momentum can carry markets only so far, at some point earnings have to matter. Even though it's no secret that the Fed's hand has guided markets for years now, historically, equity performance has a high correlation with earnings performance. However, earnings have declined four quarters in a row, the first time since 2008, and equities have maintained lofty levels. At some point, something has to give. If there was a year, and season, to be cautious, it could be 2016. It's not just earnings that are acting as headwinds, falling economic indicators are painting a challenging canvas for equities to do well from current levels. Durable goods continue to underwhelm, as do consumer confidence and GDP. Although labor markets have shown resilience, wage growth continues to stagnate and payrolls actually might be about to rollover.

It's Still About the Fed...For Now

Despite the headwinds to higher equity returns, the game is still about the Fed and what it telegraphs going forward. This may not last much longer, however. Investors have been counting on weak data to suppress the Fed and its actions. Now that the market is not pricing in a June rate hike (only a 13% probability per the CME Group), weak data may start to be viewed as bad for markets, whereas, strong data may start to look like, well, strong data, and the market could interpret this as more Fed action. It's a game investors are playing but the end may be nigh as Fed options become exhausted.