How You Can Profit While Wall Street's 'On Vacation'
"Sell in May and go away" is more than just a catchy Wall Street adage. Somewhat surprisingly, it seems to actually be how Wall Street does business. Trading volume generally peaks in May, then tapers off over the summer, only to start climbing back in September.
There are various theories for this slowdown in volume, ranging from summer vacations to the IRA contribution laws that let people put their money in for the prior year up until mid-April. Whatever the reason, lower trading volumes often bring with them higher volatility -- as we've seen with recent market swings -- and in those swings may very well be your opportunity to profit.
What's Wall Street Doing?
It's really quite astounding just how consistently volume tapers off. The chart below, covering the last 10 years of S&P 500 (^GSPC) volume, shows just how profound a slowdown there is over the summer:
When Wall Street isn't paying as close attention to what's going on, the ride can get wild. After all, the stock market is made up of willing buyers and sellers. The more participants there are in that market, the greater the chances that there'll be a willing buyer for any given seller and a willing seller for any given buyer.
When trading volume drops as people (or these days, their algorithms) stop paying close attention, it gets tougher to match up buyers and sellers. That can result in higher volatility.
What You Can Do About It
At its core, all higher volatility means is that prices whip around more. That whipsaw can be painful for investors who check their portfolio balances on a daily basis -- but it can provide an awesome opportunity for value-focused investors who are looking to buy low and sell high.
Sponsored Links The more a stock's price oscillates, after all, the less likely it'll reflect what the company behind that stock is truly worth. And the farther away from that true value a stock is trading, the easier it is for a value investor to buy (if it's trading too cheaply) or to sell (if it's trading too expensively).
The tough part is figuring out what a company's true value is, as that more or less requires you to be able to predict the future. In reality, nobody predicts the future perfectly correctly. Even a company itself doesn't know exactly what it'll deliver.
For instance, United Parcel Service (UPS) recently lowered its earnings outlook as customers shifted to lower-cost shipping options. And UPS is not alone in having that difficulty predicting the future. Earlier this year, Walmart (WMT) also guided expectations down, showing that even the world's largest retailer can't always get it right.
If You Can't Get It Right, Guess Low
Because nobody gets it perfectly right, as a value investor, you're better served by figuring out your best estimate for what the company is worth by being a bit conservative in your assumptions for its future. Then, on top of that, build in an additional fudge factor below that estimate and only be willing to buy the company's stock if it trades below that discounted level.
Indeed, it's that fudge factor that forms the foundation of the value investing strategy.
Master value investor Benjamin Graham named that fudge factor the Margin of Safety, which he called the secret of sound investing. Generations of successful value investors have made their fortunes waiting to buy companies trading far enough below their estimates of fair value so that they carry decent margins of safety.
As simple as that sounds, it can be tough to do in practice.
When the market is rising, people have a tendency to want to buy in order to get in for fear their stocks will "get away" from them. On the flip side, when the market is falling, people often become afraid to buy, on worries that stocks will continue to fall.
When you, as a value investor, look at a stock's price in terms of what the company behind it is really worth, and commit to only buy with a margin of safety, you can turn that fear and greed on its head.
Embrace Summertime Opportunity
Remember, when Wall Street is on vacation, if the market gets more volatile as fewer people are taking part in it, learn to view that volatility as an opportunity to find those bargains.
If you do, you may one day find yourself among the pantheon of value investors who've learned to profit by waiting for volatility-induced bargains and then buying great companies at discount prices.
Motley Fool contributor Chuck Saletta owns shares of United Parcel Service. The Motley Fool recommends United Parcel Service. Try any of our newsletter services free for 30 days.