In early August, I wrote "Awaiting The Next Sell Signal As The S&P 500 Enters The Season's 'Danger Zone'" as a way of analyzing the prospects for a significant sell-off by the end of October. I went on alert for a signal I now call the "200-DMA post-peak correction signal." This indicator basically estimates the likely extent of a sell-off after the 200-day moving average (DMA) ends its uptrend following an all-time high. The S&P 500 (NYSEARCA:SPY) last made an all-time closing high on August 15, 2016. Almost three months later, the 200DMA continues to trend upward thanks to the strength (really steepness) of earlier rallies.
As I demonstrated in the previous post, when it comes to average maximum drawdowns, August, September, and October are the three leading months of the year (-3.3%, -2.8%, and -3.1% respectively). Accordingly, I nicknamed them the season's danger zone. On a median basis, September fades a bit into the background and June takes it place in the top 3. Yet, THIS year, the largest drawdown these three months of danger could muster was -2% in September and October. Given that November begins a seasonally strong period for stocks, I decided to see whether a "calm" August to October has historically had any significance. I posted my data and calculations on my Google Drive for such data. (See Fidelity's "Halloween Indicator" for a concise analysis of the S&P 500's seasonal history split between November to April and May to October and a recommended portfolio rotation for shorter-term traders and investors).
For the purpose of this analysis, I defined a "calm" danger zone as one where no month from August to October experiences a maximum drawdown worse than -2.5%. Otherwise I called the danger zone "not-calm." I measured drawdowns from the last close of the previous month to the lowest close of the given month. This year qualifies as one with a calm danger zone. It turns out that since 1950 there are only 14 such years, including 2016, or 21% of years. This percentage makes 2016 a unique year.
I next looked at three different performances for the S&P 500 split between calm and not-calm years starting in 1951. The calm years delivered an average return of 18.2%. This performance significantly exceeds the average 6.6% annual performance of the not-calm years. In other words, those years where August to October fail to deliver the expected tumult, overall performance for the year benefits. This year has a LOT of catching up to do as year-to-date performance is "only" 3.3%. If the year ended here, 2016 would become the worst performing of ALL the calm years…by a longshot. The current worst performing calm year is 1993 at 7.1%.
The significant out-performance of calm years is matched for the average performance of the August, September, and October period. During calm years, these months delivered an average return of 5.5%. In not-calm years, this average return dropped to -1.1%. This year, August through October delivered a return of -2.2%, the worst of the calm years…again by a longshot. The second worst performer was 1983 with a 0.6% gain.
Finally, I wondered whether the calm of August to September bottled up the fury of sellers only to be released in the final two months of the year - the proverbial calm before the storm. On this score, calm and not-calm years showed little difference. The combined performance of November and December averaged 2.6% in calm years and 3.2% in not-calm years.
So we have a tension between the expected performance of November to December conditioned on the maximum drawdown from August to September and the expected performance of the year conditioned on this same maximum drawdown during the danger zone. This year is a unique year for its calm danger zone and the relatively poor performance of this period. The resolution of this unique tensions rests with a confluence economic and political events: a growth slowdown in China, a Federal Reserve trying to hike interest rates, and an extremely contentious U.S. Presidential election. If history holds, then the S&P 500 will rally to close out the year. THe main outstanding question would then be the strength of the rally. Perhaps only the Fed stands in the way of allowing Santa to work his seasonal magic.
For now, the unique calm has come to a telling end with the S&P 500 starting off November with a close at a 4-month low. The index even briefly touched the 2100 level. Although the danger zone did not deliver the telling blow of a large drawdown, it DID communicate growing divergences that I used as warning signals. The S&P 500 now sits at the edge of oversold trading conditions. Following history would mean buying aggressively any dip into oversold territory in the coming days or weeks.
The S&P 500 sags its way into a short-term downtrend under 50DMA resistance.Source: FreeStockCharts.com
Be careful out there!
Disclosure: I am/we are long SDS. 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.