Dow's Biggest Declines: Why October Should Be a Four Letter Word

Excerpt from Raymond James strategist Jeffrey Saut's latest essay, (published Monday October 5th):

WORST WIPEOUTS PERCENTAGE	PLUNGE
October 1987 October 1929 October 1907 October 2008 October 1932 October 1917 October 1937 October 1930	-23.22% -20.36% -14.80% -14.06% -13.50% -10.74% -10.61% -10.52%

Source: Bespoke Investment Group.

October isn’t a four-letter word, but it should be... especially with the month’s hysterical history. And while it’s true that statistically the month of September is the worst month, it should be noted that more than 40% of the Dow’s biggest daily declines have come in October. Unsurprisingly, more than 70% of the Dow’s worst “daily dives” have occurred in the September/October two-step. Accordingly, this year investors entered the dreaded month of September with a bearish mindset only to experience one of the best months on record. That wrong-footed, bearish strategy left portfolio managers scrambling for stocks right into quarter’s end, causing many folks to think there isn’t going to be an October “ouch.”

Comes October, and according to our friends at the invaluable Bespoke Investment Group, last Thursday represented the fourth worst opening day (-2.58% basis the S&P 500) of the fourth quarter since the index data began in 1928; it was also a 90% downside day. While we are clearly not clairvoyant, we did indeed caution that the upside vacuum created by the recent melt-up might get “filled” on the downside once third quarter’s window-dressing was over. Consequently, we entered 4Q09 with a cautious, but not bearish, strategy. And while the jury is still out, our confidence level is rising that for the first time since the March “lows” we have the potential for a correction of more than 7%. The only question to us is what shape the correction will take? Will it resemble the smash of October 1978, which saw the senior index surrender more than 10% in three weeks, or will it lay around and then dribble-down in a slow-motion “melt?”

Think about it, last November we were opining that while most participants were waiting for the worst to happen, the second shoe to fall, we were screaming that the worst had already happened given Lehman (LEHMQ.PK), WaMu, Freddie (FRE), Fannie (FNM), etc. “If the news gets any worse,” we wrote, “they will have to close the New York Stock Exchange and we will retire.” The environment we have now is the exact opposite. Participants are currently moving up the “risk curve” to invest their oversized cash positions in stocks that have the “right stuff.” While in the long-run we think that will be a rewarding strategy, in the short-run we believe more caution is warranted; and evidently we are not the only ones.

Indeed, just last week Richard Russell, of the Dow Theory Letters fame, removed the bull picture from the top of his letterhead. To quote him,

I'm removing the bull from the box. With the Industrials, Transports, Utilities and S&P all ‘rolling over,’ I'm thinking that the counter-trend rally from the March low is in the process of topping out. The Dow has declined six out of the last seven sessions; and, the MACD is on a well-defined sell-signal.

Now people that live in glass houses should not throw stones, but hey Richard, Richard Russell, by your own interpretation of Dow Theory you stated on July 23, 2009:

After six weeks of trying, it looks as though the Transports have finally decided to confirm the Industrials. In case you forgot, the June peaks are the points that we have been watching. The two charts tell the Dow Theory story. The first chart shows the Dow surging above its June 12 peak of 8799.26. The (second) chart shows the long-awaited confirmation by the Transports as they surge through their June 23 peak of 3399.88. The question – what are the Transports telling us? And my answer is ‘who cares?’ In the great majority of instances, we don’t know the reason why the stock Averages are doing this or that. We follow the Averages blindly (via Dow Theory) the way a blind man follows his Seeing Eye dog. And when we mix technical analysis with our own “common sense’ and emotions, we are on the path of going wrong... As I write, we’re halfway through today’s session. BOTH the Industrials and Transports are up over 100 points. This is what I call a powerful confirmation, a twin breakout with force. The implications are that the market is heading higher.

While by our method of interpreting Dow Theory we didn’t get the Dow Theory “buy signal” until a few weeks later, it was still a “buy signal.” And, it reinforced what we have been saying since the March lows. To wit, “we are treating the equity markets as if we are in a new bull market, but are leaving the final bull market ‘call’ to Dow Theory.” Now as I learned it, once you have a Dow Theory “buy signal” it stays in force until you get a Dow Theory “sell signal.”

For example, the Dow Theory “sell signal” of September 1999 was not reversed until the Dow Theory “buy signal” of June 2003. Similarly, the Dow Theory “sell signal” of November 2007 was not reversed until the recent “buy signal.” So I have to ask the question if – “we follow the Averages blindly (via Dow Theory) the way a blind man follows his Seeing Eye dog” – how can Dick Russell take the “bull out of the box” without the prerequisite Dow Theory “sell signal?”

Obviously, we don’t think the bull should be taken out of the box even though we do believe the odds for the first decent correction since the “lows” are rising. That said, we would be buyers on said correction, believing stocks will be higher by year-end than they are now. We continue to prefer names with dividend yields like CenturyTel (CTL/$32.62/Outperform) and NTELOS (NTLS/$16.96/ Strong Buy); and would note that NTELOS was added to the Focus List last week. For other yield-oriented ideas we urge you to listen to one of our Canadian energy analysts, Kristopher Zack, speak on the Canadian Oil & Gas Trust Sector on the International Call of the Month this Wednesday (October 7th) at 4:15 p.m.

The call for this week: Mark Twain’s quote seems to put the month of October in perspective:

October. This is one of the peculiarly dangerous months to speculate in stocks. Others are November, December, January, February, March, April, May, June, July, August, and September.

And as our technical analyst, Art Huprich, wrote last Friday:

Finally, relative to today’s employment report, as James DePorre wrote yesterday, ‘the response to that report is going to give us a good insight into the health of the market. If market players buy a pullback on a bad report or sell strength on good news that will be an important tipoff. The bulls need to build on good news or buy the dip on bad news. If they don't renew their interest in buying market weakness, the downside is going to gain momentum quickly.’ I would agree.

Comments

[tc1:]

On the "scariness" of October as an investing month, notice that only 1 out of 8 Oct. "crashes" listed above occurred within the last 22 years, and only 2 out of 8 occurred within the last 72 years.

Decent earnings reports this Oct in most sectors should keep this a fairly healthy month for investment returns in this incipient (albeit anemic) recovery.

The one warning flag is the state of regional banks and defaulting commercial and consumer loans.

If any correction is coming this Fall, i surmise it's only going to be 4% to 8% at worst. We may also be in for yet another positive overall month.

Happy investing!

Oct 10 03:40 PM