A Bearish Case For November

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Includes: DIA, QQQ, SPY
by: Investment U

By Justin Dove

What a ride we had in October…

This past October was the best month for stock market gains since October 1974 and the second best month for the S&P 500 since 1950.

October 2011 Best Market Month Since 1974

(Courtesy: Oppenheimer & Co., Business Insider)

According to a Wall Street Journal article on Monday about the Stock Trader’s Almanac, October was traditionally a strong month for the markets, despite precipitous drops seen in the Octobers of 1929, 1987 and 2008.

In fact, October ended bear markets in 12 instances since World War II. It’s traditionally the strongest month of the year for the markets, while December is second and November is third – meaning the strong October usually leads into a strong finish.

“I think the end of the year is going to finish pretty nicely for the stock market, though we could have some bumps along the way,” Robert Pavlik, Chief Market Strategist at Banyan Partners, told The Wall Street Journal.

Market Fundamentals: Long Term Vs. Short Term

As Marc Lichtenfeld wrote last week, fundamentals are looking good for the long-term trajectory of the stock market. According to Thomson Reuters, stocks are still trading at about 12.2 times forward earnings – still well below the historical average of about 16 or 17 times.

But not everyone is buying into the rally yet.

The following three graphs are from a MacroStory.com article showing how non-commercial investors are currently playing the options market.

Non-commercial investors are defined as large speculators such as hedge funds and banks. While they’re somewhat of a lagging indicator, they still haven’t deviated too far from the S&P 500, until now.

Hedge Funds and Banks vs. S&P 500

Next is a graph displaying the level of hedge positions in the market. For the hedge line, the higher it is, the less hedging. You can see that recently investor hedges have been increasing rather than decreasing.

Level of Hedge Positions in S&P 500

Below is the position delta versus the SPX. If the delta is positive, then the trade is positioned for higher prices and vice versa for negative prices. The more negative the delta, the more the position profits in falling prices and vice versa.

Position Delta vs. SPX

Adding more fuel to the fire is that after the large rise in October 1974, November and December were weak and the market finished the year around the levels it started at in October. Maybe this history has investors hesitant to buy into the most recent rally.

Speculation is Just That

Leading indicators such as auto and retail sales, purchasing manager’s index and housing starts are all looking good right now. That’s part of what contributed to the run in the second half of October. A possible resolution to the European debt crisis also undoubtedly helped the markets.

But the initial exuberance of the Eurozone’s plan has faded and investors are still unsure if the resolution will be permanent. There’s also the possibility that such a volatile market has many investors so shell-shocked it’ll take more than one positive month for them to return to risky assets.

While speculation, such as the ones displayed in the graphs above, is typically a lagging indicator, there may be some good information to pull from them. While there are some strong signs to a good ending to the year, investors would be naïve to ignore possible signs toward the contrary. Be confident of the market eventually returning to its average valuation of 16 to 17 times forward earnings – but remember to tread carefully.

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