Interview With Financial Sense on Macro Risks and The Market Correction

We were interviewed by Cris Sheridan of Financial Sense on November 12th. During the interview we discuss the macro-economic environment, specific risks that are unfolding and current market technicals as stocks suffer their second correction in 2018. One theme of our discussion is what to look for over the next several months.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

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Interview on Real Vision Television

We were interviewed on Real Vision Television on May 29th. During the interview, we discuss our long term equity market view, the current macro-economic environment and market technicals.

Our thanks to Real Vision for the opportunity to share our thoughts. Click here to become a subscriber.

To watch the interview, click here.

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Trading The "Worst 6 Months" and the Presidential Cycle

Summary: There are two seasonal patterns currently in play for investors: the weak "mid-term election cycle" and the weak "summer months." Is the next half year a landmine for investors? The short answer is no.

Since 1982, the average mid-term year has gained 9%. In fact, mid-term years have been better than the supposedly awesome Year 3 of the presidential cycle more than half the time in the past 36 years.

The same point can be made about summer seasonality. While it's true that returns and the odds of gains are typically lower over the next six months than in winter, seasonality still favors longs. If you sell in May, you should expect to buy back higher in November.  For most investors, that's all that matters.

For swing traders, seasonal patterns suggest a general strategy to keep in mind. A swoon in May-June often sets up a bounce higher in July. Likewise, a swoon in August-September often sets up a bounce into October and the end of the year. That also corresponds with the mid-term cycle, which typically has a seasonal low point in September before a ramp into 4Q and into Year 3.

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There are two seasonal patterns currently in play for investors: the "mid-term election cycle" and the "summer months." Neither points to negative returns but both point to lower than average returns. There is also some nuance to the patterns that suggest a potential strategy for swing traders to keep in mind.

First, the mid-term election cycle: The second year of a president's term is generally considered the weakest of the four year cycle for stocks. To make matters worse, that seasonal weakness is most pronounced from now until October (red box; from BAML).

Sell in May And Buy Back Higher In November

Summary: The "summer months" start next week. The period from May through October is known as the "worst 6 months" of the year for stocks. True, the probability of a truly bad month is higher and the probability of a really great stretch of months is lower during the summer than in the winter. But, overall, the expected return over the next 6 months is positive: median returns in winter and summer since 1970 are nearly the same. You might very well sell in May and buy back higher in November.

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One of the axioms of Wall Street is 'sell in May and buy after Halloween'.  Mark Hulbert says that over the past 50 years, the Dow has an average return of 7.5% from November through April ("winter") versus an average loss of 0.1% from May through October ("summer").

So, is the summer period that awful?

Using SPX instead of the Dow, the data since 1970 still favors winter over summer: the average return is 6% in winter versus 2% in summer.

But this data is skewed by a few outliers; stocks fell 37% in the summer of 2008, by 20% in 1974 and 15% in 1987, to name a few.

Using median values, winter's return is 5% versus 4% in summer. That's a very small difference. The returns in summer are typically positive, meaning, you might very well sell in May and buy back higher in November.

Overall, 76% of winters since 1970 have been positive; fewer summers are positive (67%), but the difference is slight.

So why do investors fear the summer months?  There are two reasons.

First: since 1970, 64% of the worst months (in which stocks fell 5% or more) occurred during the summer.  A bad month is twice as likely during the summer as the winter. 

Moreover, really bad seasons with losses of more than 10% occur more often in the summer: 13% of summers experience a "correction" versus only 4% of winters.

Second: great returns overwhelming take place in winter. 37% of winters produce a return of 10% or more. In comparison, only 17% of summers have produced a great return. A good stretch in the market is more than twice as likely during the winter as the summer.

Why Year 3 of the Presidential Cycle Hasn't Gone The Way Everyone Expected

Summary: Year 3 of the "Presidential Cycle" was expected to post a gain of over 20%. Instead, SPX is down 3% from a year ago. Why? The set up was all wrong, which brings up a basic principle in analyzing markets: patterns work for a reason, and if that context is missing, the pattern will probably fail. In the event, this is what has happened.

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A year ago, we wrote a post on why "Year 3 of The Presidential Cycle Is Unlikely To Go The Way Everyone Expects" (here). At the time, SPX had risen 10% in the prior two weeks. The consensus was firmly in the camp that this performance would continue. After all, since 1950, SPX has risen an average of 22% during this phase of the cycle. In the past 60 years, Year 3 has never provided a negative return.

The Bullish "Year 5" Set Up Is Missing A Key Ingredient

Patterns in the stock market primarily persist for a reason.

For example, downtrends are frequently reversed on Tuesdays. Why? Spooked investors may not want to hold risk over the weekend, so they sell on Friday. That weakness can persist through Monday. By Tuesday, stocks are relatively oversold and tend to rise.

Another example is the tendency for stocks to rise in the last 3 weeks of the year as managers chase performance or dress up their portfolios for year end statements to investors.

Which brings us to the tendency for stocks to rise in years ending with the number 5. This is 2015, so this matters. In the past 130 years, the Dow has risen an average of 29% in years ending with the number 5. Since 1900, years ending in 5 have been up 10 of 11 times.

There must be a reason why this has worked so well and so consistently. Indeed there is.

In 6 of the 10 times that stocks have been higher in years ending in 5, the market was down in at least one of the two prior years (red boxes). In other words, most of the time investors are coming into years ending in 5 having been recently shaken out.

Low Odds of a Big Fall in December

Bond yields are falling, as are commodity prices. Both NDX and RUT are starting December down more than 1%. Is a December swoon set to trigger?

Based purely on seasonal tendencies, the odds of a steep fall in equities through the end of the year are low.

According to the Stock Traders Almanac, December is the single best month for SPX (since 1950) and RUT and the second best month for NDX (post). Whether you look at the last 20, 50 or 100 years, December has averaged gains for SPX (chart from Bespoke).

Year 3 of The Presidential Cycle Is Unlikely To Go The Way Everyone Expects

If you even passively follow equity markets, chances are high you have already read a number of articles about "Year 3 of the Presidential Cycle". That period is starting right now, and it's incredibly bullish. In the chart below, we are entering the steep ascent where the SPX has risen 22% in a year on average (since 1950).

The Set Up For A 4th Quarter Rally Is Missing Something

The end of the year is known for being seasonally strong. Even October, renowned as the month for exceptional drops, has recently been one of the best months of the year. Over the past 20 years, the October - December stretch has been the strongest period of the year (chart from Bespoke).

That is especially true during mid-term election years. These years usually meander until the 4th quarter, and then rally. Crucially, that continues into the third presidential year when stock returns are the greatest (chart from BAML).

An Update on May to October Seasonality

In a sign of how short investors' memories are, one of the newest memes is that equities are unlikely to be weak this summer because they already corrected during the first four months of the year.

Anyone remember 2010 or 2011? Both started weak and got weaker in the middle of the year.

How about 2000, 2001, 2002, 2004, 2005, 2007 or 2008? Weakness early in each of these years did not preclude a second period of weakness in summer.

Time to Tank Up With Oil?

Oil has a seasonal tendency to peak in September and trough in early December. The period for positive seasonality (green shading) is now close at hand (data from Stock Trader's Almanac).

Sentiment follows the same pattern. It's now at a low where crude oil prices have tended to move higher (data from Sentimentrader).

The Best Six Months Start Now

The end of the "worst 6 months" in the stock market is upon us. Tomorrow is November 1, when seasonality turns positive.

We last wrote about seasonality in April. Our bottom-line was this: May to October is less bad than you think (post). Median returns since 1970 on SPX are 8% during winter (November to April) and 4% during summer (May to October). "You might sell in May and buy back higher in November."

This summer was exceptionally strong: since May 1, SPX is up almost 11%. This puts it in the top 17% over the past > 40 years.

Below are the SPX returns by season since 1970. Summers are red and winters are blue. The arrows show returns in the summer of over 10%.

What to expect in the month's ahead? Normally, a very good return.

May To October Is Less Bad Than You Think

One of the axioms of Wall Street is 'sell in May and buy after Halloween'.  Mark Hulbert says that over the past 50 years, the Dow has an average return of 7.5% from November through April ("winter") versus an average loss of 0.1% from May through October ("summer").

So, is the summer period that awful?

Using SPX instead of the Dow and including dividends, since 1970, the data still favors winter over summer: the average return is 9% in winter versus 2% in summer.

But this data is skewed by some outliers; using median values, winter's return is 8% versus 4% in summer. In other words, while the returns are usually two times higher during winter, the returns in summer are typically positive. You might sell in May and buy back higher in November.

Digging in further confirms this conclusion. Overall, 21% of winters since 1970 have been negative; summers are a bit higher at 28%. Really bad seasons with losses of more than 10% don't favor one season over the other: 7% of winters versus 12% of summers. Summer is worse, but the difference isn't much.

There are two factors at play influencing typical seasonal returns and investor perceptions.

The first one is this: about 65% of the worst months since 1970 occurred during the summer. This is true whether you look at the top 20 worst months or all months with a 5% or greater loss. When a bad month happens, it is twice as likely during the summer as the winter. 

But the other factor, equally important, is that great returns overwhelming take place in winter. Almost half (48%) of winters produce a return of 10% or more, just like the one occurring now. In comparison, only 17% of summers have produced a great return. When a good stretch in the market happens, it is almost three times as likely during the winter as the summer.

The summer months start in a few weeks. The probability of a truly bad month is higher and the probability of a really great stretch of months is much lower. But the expected return over the next 6 months is, on its own, positive. As we have seen in the past few years, a dip in summer is often a great entry point.

What to Expect in April

The best six months of the year are November through April. April is particularly strong, with the Dow up more in April than any other month over the past 20 years and the past 50 years.

Post-election years are particularly strong for April; according to Stock Traders Almanac, April is the second best month for the Dow and the fourth best for SPX. A number of good charts on performance during April can be found here.

So, all is good, right? A few caveats worth keeping in mind:

First, SPX has been up every month starting in November 2012. It has not also closed higher in April after that long a stretch in the past 15 years. Put another way, April has been strong partly because at least one of the prior 5 months has provided a dip. That hasn't happened this year. Since 1980, there has been a 5% dip before April 90% of the time (here).

Second, the post-election pattern is for a weak March followed by a strong April. March in these years is typically one of the worst of the year. Unless something dramatic happens Thursday, March will close up strongly (right now, it is up 3%). This pattern is apparently off.

Third, April has been a key turning point in many years in the past, especially the past 3. Those years bear a strong similarity to 2013. See the chart below. Why is it a turning point? Because April is also the last month before the traditionally weakest 6 months of the trading calendar, a period when bonds have a pronounced tendency to outperform (read here). Trade the trader.

Time To Short Treasuries?

There are three data points you might want to consider before deciding to swing at that pitch.

Short Side of Long (with a new publication I recommend reading, here) uses COT data for small speculators to show that they are already way ahead of you. As a group, they are mega short, which has previously been the signal to look long instead.

There's More Than a 90% Probability of a SPX Correction Before April

That's a Business Insider-type title. Have to grab you.

We have been anticipating strong resistance between 1555 and 1575. SPX is now trading 1% off the top of this range. As Ryan Detrick points out, the past 10-day-in-a-row-advance in the Dow is the weakest since 1990. We think the SPX resistance zone is likely a main reason. 

Another reason is timing. SPX has had at least one 5% correction by May every year since 1996. 

The same can be said about every year since 1980, with only 3 exceptions: 1985 (it corrected in June), 1989 (September) and 1995 (none). Those exceptions bear no resemblance to today as the prior year in each case was either flat or strongly down and demand was therefore pent up. Last year, in comparison, SPX rose 12%.  In the first chart below (zig zag 5%), those exceptions are shaded yellow. 

The key is this: excluding those years, SPX has had at least one 5% by the end of March 93% of the time since 1980. If you include the first week in April, the probability rises to 97%. Even if you include those other years (1985, 1989, 1995), the probability is 88%. The current trend is running headlong into an exceptional bias. 

What To Expect in March and April

The strongest 6 months of the calendar run from November through April. November through January is traditionally the strongest 3 month stretch of the year.

February is the weak link in the 6 month chain. Seasonal strength returns in March and April. 

In the first chart (from SentimenTrader), you can see that March and April are up 65% of the time on average for 1 to 2.6% gains each month. 

The second chart (from David Stendahl) shows March and April are strong whether viewed over the past 5, 10 or 15 years. Adding granularity, March seems to start weak and then rip from mid-month onwards.

The potential fly in the ointment is that in post-election years, March is weak (see third chart). As Stock Trader's Almanac says: "In post-election years, March ranks 5th worst for DJIA, S&P 500 and Russell 2000. NASDAQ is 4th worst. In 10 post-election years since 1973, NASDAQ has advanced just four times in March."

Getting too granular or literal on seasonality is not a great investing approach in the absence of other confirming factors. That said, April is typically solid, and if March presents a nice dip, seasonality is a tailwind on the long side (see fourth chart). 

Charts below.

Nasdaq Negative in February Every Post-Election Year Since 1985

Stock Trader's Almanac has this to say about February:

1. Since 1950, January $SPX gains of 2% or more corrected or consolidated in February 67.9% of the time. 
2. In the 19 years that $SPX gained 4% or more in January, 68.4% of the time it declined or finished flat (less than 1% gain) in February. 
3. February’s post-election year performance since 1950 is miserable, ranking dead last for DJIA, $SPX, NASDAQ, Russell 1000 and Russell 2000. 
4. NASDAQ has not posted a post-election year February gain since 1985.

February Has Tended to Be Flat for $DJIA

The strongest 6 months are from October to April. Within this period, the strongest three month stretch is November-January; the stretch we just finished. February tends to be the pause month - flat on average - before better seasonality in March and April.

McClellan: 40 Year Cycle in DJIA

A chart from Tom McClellan showing the DJIA 40 year cycle. Each point on the chart is compared to the period 40 years prior. According to this cycle, a big bottom is coming up in 2014 following a big top this year.