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Why selling in May may be dangerous

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange.

There's a lot to be said for the "sell in May" theory, the old Wall Street maxim that predicts stocks will sink from mid-spring through fall, and then outperform the rest of the year.

But some strategists expect this year to be different, despite what seems to be a growing list of red flags, and investors could miss out if they sit on the sidelines.

A pending Federal Reserve rate hike, shaky economic data and mixed corporate earnings all loom as potential negatives for stocks. Yet, a number of strategists expect the S&P 500 to break out after resolving a 2,120 level of resistance, surpassed Monday morning.

"(Sell in May) does usually work if the kind of environment is suggestive that it would," said Ari Wald, technical strategist at Oppenheimer Asset Management. "You'd have weakness going into it, when breadth is weaker as well. What we're seeing in more critical indicators suggests you might not get it."

Wald says since 1950, the S&P 500 averaged a 1.7 percent gain in May through October, while it rose an average 13.9 percent in the period of November through April. So far this year, the S&P 500 is up 3.2 percent and has gained 2.7 percent in April, and Wald expects it to get to 2,250 at some point this year.

"Underneath the surface, conditions are quite strong and it's been five months of this choppy trade, and the market has lacked direction," said Wald. "Our bet is due to the strong internal breadth behavior, this ultimately resolves to the upside and after so many months of indecision, our theory is the you get a grind higher this summer."

Morgan Stanley strategists in a note Monday said they believe the consensus view that stocks will be choppy and the end the year slightly higher is wrong.

"We don't see sentiment on U.S. equities as ebullient and we like the fact that net hedge fund exposures in the U.S. appear to be exactly in line with five-year averages, and sentiment about other equity regions is clearly more positive than for the U.S. That's a good set-up for meaningful appreciation," they wrote in a note titled "We are full of bull."

Wald says the "sell in May" adage works well when the S&P 500 is below its 200-day moving average. But it is now well above the 200-day moving average of 2,024, and has been setting new highs.

This year, the index is in an uptrend and could benefit from the added seasonal lift of the market's typically stronger performance in the third year of a second-term president, Wald said.

He also said the Fed rate hike, now expected in September or December, is not likely to hurt the stock market initially.

Read MoreS&P 'triangle pattern' points to more gains

"The Fed hasn't come in. Futures are pricing in a fourth-quarter hike. ... That's a long period and history would suggest performance tends to be stronger, heading into that," he said. "That to me supports this rally. Once you do get the hike, you'll get volatility and performance is more mixed. If you look at history, rarely does the first hike coincide with a market top. It usually takes a few rounds."

When the S&P is in an uptrend, as signaled by its 200-day moving average, the months of May, June and July averaged gains since 1950 of 0.3 percent, 0.7 percent and 1.3 percent, respectively. When the S&P was below its 200-day moving average, the index lost an average 0.1 percent in May, 1.7 percent in June and was flat in July, according to Oppenheimer.

Another factor that could support stocks this year is that investors have lost some of their optimism, a contrarian market headwind. The Opco Sentiment Composite from Oppenheimer fell to the lower end of its trading range at 63 percent bullishness from 85 percent bullishness in December.

Read More10 stocks that almost always beat earnings

"I think we do end up breaking out to the upside based on what our indicators are telling us. We're constructive on the market here. We're not making the case on a breakout, based on seasonals. Why we're thinking we're going to get a break out is, if you look at the participation at the stock level, it's been very positive. More stocks are making new highs. The advance/decline line is at a new high," said Wald.

Last year, the "sell in May" theory had more potential going into the summer period. "A lot of these indicators weren't confirming the advance, and now the small caps are breaking out to the upside again. We're seeing the confirmation of the advance/decline line and that it's causing this broad-based strength we didn't have last year. We think this year is going to be better than last year for your average stock," he said.

Wald described last year's May to October activity as "selective." "Last year, we did have this stealth bear market on the onset of the May period. Small caps started to languish there but the S&P held up," he said.

Jeff Hirsch, editor in chief of Stock Trader's Almanac, said he recommends switching to a more defensive bias in the weaker second-quarter period, coinciding with the "sell in May" period that his publication helped popularize. "The market did a whole lot of nothing during the May to October period last year ... while it wasn't down from April [30] to Oct. 31, we did have more volatility, more pullbacks and much smaller gains," he said.

Hirsch said the Dow was up 2.3 percent from mid-April to mid-October, and it's now up about 10 percent since Oct. 31. "The 'sell in May' thing gets everybody a little worked up," he said, adding, instead of a seasonal decline, there could just be shorter time periods within the period where investors should be more defensive.