What is the life of man! Is it not to shift from side to side? From sorrow to sorrow? To button up one cause of vexation! And unbutton another! - Laurence Sterne
Like most of my colleagues, I have been an avid viewer of the hit HBO television series Game of Thrones. The series involves several families vying for "The Iron Throne" (for anyone interested in Game Theory, I strongly suggest you read the fantasy novels "A Song of Fire and Ice" by George Martin or follow the television series). One particular phrase that fascinated me during the first two seasons of Game of Thrones is "Winter Is Coming." After a fairly long and warm summer, the people of Winterfell are expecting a long, harsh winter season. The phrase is a forewarning that rough times are ahead and stresses the need to be prepared.
The "Winter is Coming" theme is as applicable to the people of Winterfell as it is to capital markets today. Seasonality in capital markets plays a major role in asset prices. Seasonality refers to a cycle that occurs yearly. Some years the magnitude of the fluctuations may be lower than expected, while other years they may be higher; in either scenario the concept holds true. The majority of investors focus on tracking the effect of seasonality in commodities, particularly grains and beans. But there exist cycles in the equity, fixed income and the foreign exchange markets.
Most notable are the equity market expressions of seasonality such as the "January Effect" and "sell in May and go away." Other investors may recollect famous market corrections, such as Black Monday (October 28, 1929) and the market crash of October 19, 1987. If we delve deeper into the historical data we may derive some truth to the existence of seasonality in U.S. equity markets. Tabulated below is the monthly price change over 2002-2011 of SPY, which broadly represents the U.S. equity market.
From the table we can see that over the period 2002-2011 June was the most consistent with monthly declines. Not surprisingly, October had the worst single monthly decline of 16.52% in 2008. The months with the most consistent monthly price increases over the period 2001-2011 were April, August, October and December. Ironically, October had the best price increase in the sample of 10.91% in 2011. April has the highest average monthly increase of 2.37% while June had the lowest with -2.51%.
2012 has so far been a fairly quiet year for declines, with only April and May posting negative monthly figures for SPY. Again viewing the table above the years 2002-2011 had an average of five months that declined. With the first six months of 2012 behind us, is it possible that we see three more monthly declines for SPY in 2012?
Fundamentally, No Signs of Snow
Like Game of Thrones, the majority of the S&P environment has no signs of winter. Earnings season is almost over and of the 474 companies that reported earnings, 71% beat mean estimates. From a Price/Earnings perspective, the Forward 12-Month P/E of the S&P 500 is 12.7, which is below both its five year and 10 year averages of 13.1 and 14.4 respectively. This is graphically shown below.
When the S&P 500 is broken down on a sectored level as seen below, only the Telecommunication Services and Utilities sectors' Forward 12-month P/E are above their 10-year average. From this data, one can conclude that the S&P 500, and by extension SPY, have more upside potential.
Technically speaking, Winter is Coming
The image above is that of the White-Walker. He was first seen in the season two finale of Game of Thrones. It has been ingrained in my mind ever since and I anxiously anticipate the third season of the HBO television series. Unlike the White-Walker, the upward price movement in the VXX, has not been seen but may appear in the same sequence as it did in the finale, as a surprise. The VXX is the S&P 500 VIX Short-Term Futures which is designed to provide access to equity market volatility in 1st and second month VIX futures contracts. VXX has a -0.79 correlation to the S&P 500 Index and is used by investors to hedge their portfolios in times of volatility or "winter."
While the overall trend in VXX in the medium term is down as illustrated in the chart above, the security is approaching oversold levels in the short term as seen in the chart below. As VXX becomes oversold, a short term bounce would be expected. In my opinion investors should wait for this moment to time the reversal.
In the medium term, SPY remains constructive, as it seems to be in an ascending triangle set-up, with the horizontal base at 142.60 price level. The chart below is a weekly candle-stick chart of SPY.
Unfortunately in the short term, SPY is approaching oversold levels at 69.40 and is trading at resistance. This is an indication of a short-term pullback, or a correction. Best estimates for the pullback are towards the blue trendline seen in the image below.
Season 3 Preview
In the short term it is expected that the markets will vex VXX and let SPY fall into winter. However, market fundamentals on SPY remain strong and this season's winter may not be severe. This narrative does not imply to sell your entire portfolio and seek warmth but rather hedge your positions by setting trailing stops, shorting SPY or purchasing some historically low VXX.
Disclaimer: The views expressed in this article are my own and are not necessarily the views of any companies or organizations I am affiliated. I expressly disclaim all liability in respect to actions taken based on any or all of the information in this writing.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.