Beware The Seasonal Market Trap

Includes: DIA, IWM, SPY
by: Kevin Flynn, CFA

If you're serious enough about investing to be reading this, you're probably aware that the S&P 500 briefly poked through 1500 yesterday. The first attempt at such levels is usually swatted away, so don't despair if you're long. Traders will want to give it another try. If you're wondering whether it will be back soon, the answer will probably depend on the new home sales data Friday morning. It had better poke through quickly, or it could take two or three weeks (or even months) longer.

The biggest impetus to a market that's been dying to break through the magic number, but hasn't gotten the help from earnings yet, has come from consecutive weekly jobless claims reports that have many black boxes clicking away and many analysts mystified.

The previous week's big 10% drop was made possibly by the largest seasonal adjustment factor in three years. Unadjusted claims were up year-on-year, but were reported as down; the same result obtained in this week's report. It's a puzzle.

For the first three reporting weeks of January 2012, one year ago, real claims totaled 1,588,521 through January 21st. In January 2013, the first three periods ended January 19th and real claims were 1,550,272, according to the most recent DOL data. That's a decline of 2.4% from 2012. Adjusted claims over the same period went from 1,126,000 to 1,040,000, for a decline of 7.6%. That's a remarkable difference, three times the change in the actual data. I don't get it.

It's true that the 2012 period included the Martin Luther King holiday, and the 2013 period stopped two days short. However. the 19th of 2013 (Saturday) was the first day of the long MLK weekend; any holiday-related shortfall should have been in the raw data anyway. It doesn't explain the unusually large adjustment factor for the week of January 12th, either.

Weekly jobless claims ran in a steady pattern throughout 2012. With the exception of the Hurricane Sandy period, weekly real claims generally showed a year-on-year decline of about 7%-12%, with 10% being a good rule of thumb. The 2013 data is showing an increase the last two weeks in actual claims, and are only down 2.4% so far from 2012. For some reason, they were reported as a much larger decline.

In both 2011 and 2012, the strength of the economy was exaggerated in the first quarter by seasonal adjustment factors applied to the data. In 2011, several data series were later revised downward after the first quarter had ended. In 2012, we had the warmest year on record and an exceptionally mild winter that was in effect ignored by the seasonal adjustment factors, which are calculated in advance.

The real pace of economic activity was slowing in the first quarter of 2012, but the adjustment factors had the black boxes (programmed to buy reports of positive economic surprises) humming away, lifting the tape and generating talk about the economy reaching "escape velocity." In fact, GDP slowed throughout the first half of the year.

The question is whether we are now doomed to repeat this pattern in 2013. I cannot see why we should, though I don't think seasonal patterns will disappear either, not without some exogenous shock (a long way of saying "Iran," perhaps). The weather is much more seasonal this year and indeed much of the country has been dealing with episodes of very low temperatures. Then again, I cannot explain why the recent claims data is skewed so low, either.

I don't believe that the Labor Department or any other reporting agency cooks the books, but I do know that they can make mistakes. One of the questions uppermost in my mind at the moment is whether the seasonal adjustment process used for the monthly employment report is the same as or similar to the one used for weekly claims, and it was too late to call the department when I thought to ask (if anyone knows off the top of their head, feel free to post accordingly, though I will check with Labor anyway).

Unadjusted data estimates do come with the monthly jobs data, as they do with claims, but in both cases the tape trades the headline adjusted number, not the underlying one. If the monthly report uses similar methodology, then we could be in for an overestimated number next week that cranks the market back up.

The stock market has long had an upward seasonal bias built into the first quarter and the first month of the year, which is why we have the old adage about the year going as January goes. It isn't perfect, but the truth of the adage lies in knowing that if January is down despite the strong seasonal bias, the market is in for a struggle.

This bias seems to have been heightened in recent years by a feedback loop between behavioral trading algorithms that presume a rising first quarter, and government data that apparently has been struggling to make sense of the quarter ever since the difficult years of 2008-2009. Stock prices rip through the first quarter, then collapse in late April and early May when neither earnings nor economic reality are able to live up to their billing. Throw in distortions caused by high frequency trading (HFT), and the swings get bigger. The collapse gets exaggerated as well, partly by the change in data, and partly by the same algorithms being modeled to exit quickly at the first sign of the annual mid-spring stall.

In any case, markets are now overextended and one of two directions lie ahead. The more likely is that the current move begins to stall as early as today (Friday) or Monday. I've been advocating that traders fade the move to 1500, but it took longer than anticipated and Thursday was the first day I began selling six-month call options and taking profits in individual positions.

I'm certainly aware of the 1510 target level that many have in mind as a Fibonacci level (see Jim Cramer's exposition thereof here), and if we do get there or nearby on the back of some report Friday or Monday, then I will fade the move more aggressively. Many traders would prefer to see some sort of pullback develop over the next week, on the grounds that some consolidation would leave the tape better positioned for advances later in the quarter.

That doesn't mean, of course, that it will happen. The other possibility is that there is no January pullback and the black boxes drag prices higher through the 1500-1510 zone, possibly in anticipation of the January jobs report next Friday or perhaps spurred on by some other set of data. That looks to me like the less likely scenario, but it's certainly within reach. In that case prices would get to an extremely overextended posture, and the later resulting correction would be sharper.

Consider the warning signs. Citigroup's economic surprise index just turned negative. Inflows into equity mutual funds and ETFs are the highest since mid-2008 and 2001, both excellent times to leave the market. Bullish sentiment is very high, with bullishness amongst global managers at a two-year high. Earnings growth is 2%. Prices are seriously extended.

The Fibonacci level may or may not come true in the next couple of days, but do keep in mind the old Street adage about bulls, bears, and pigs. If you keep your positions intact in the hopes of hitting the widely-anticipated target exactly, good luck. But if you start jumping in now with new money, you have almost no margin of error and will get no sympathy.

Some were curious last week as to why I posited on Wednesday that Apple (NASDAQ:AAPL) would close the week at $500. It was because Friday was an options expiration day, and I noted that there was an imbalance with two days to go. Over 200,000 call options had a strike price of $500 or higher, and over 200,000 put options had a strike of $500 or lower. All of them were worth varying amounts of money on Wednesday, some quite a lot, and all of them would be crushed by an expiration price near $500. Apple closed at $500.00 exactly, rendering all 400,000 of those contracts worthless. It's a wonderful world.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.