Don't Panic Over a Deep October Drawdown

October is notorious for steep stock losses, but seasonality points to an improving picture just around the corner

Oct 17, 2016 at 8:37 AM
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U.S. stocks started last week on a quiet note, as banks and the Treasury market were closed Monday for Columbus Day. But things didn't stay calm for long, as third-quarter earnings season unofficially kicked off with Alcoa's (AA) disappointing report, long-term rates and the U.S. dollar continued to rise, and the Fed remained in focus as the September meeting minutes were released. Further adding to the mix of headlines was China's disappointing trade balance report for September. Add it all up, and we had a week of significant volatility that saw the S&P 500 Index (SPX - 2,132.98) down nearly 2% mid-week, but erasing most of those losses by Friday's close.

Currency and interest rate movements are not a new theme to tackle this week. Since the beginning of September, long-term interest rates have gained more than 13% and the U.S. dollar has gained nearly 2%. The increase in interest rates comes as more market participants expect the Federal Open Market Committee (FOMC) to raise interest rates at its December meeting. The CME Group 30-day fed funds futures currently predict a 64% probability of a December interest rate hike. (It's important to note that the Fed also has a meeting in early November, but most don't expect any changes just days ahead of the presidential election, and absent a scheduled press conference with Fed Chair Janet Yellen.) Meanwhile, currency fluctuations could be very important for multinational companies doing business overseas, which could be a theme for the third- and fourth-quarter earnings seasons.

TYX daily price chart
Chart courtesy of StockCharts.com

Despite the recent developments in rates and currencies, the U.S. stock market had been stuck in a pretty narrow trading range over the past couple of weeks. In fact, the SPX experienced two inside weeks in a row coming into last week. An "inside week" occurs when the entire weekly price range for a given security falls within the price range of the previous week. Seeing two consecutive inside weeks is very rare. Like a coiling spring wound too tight, the SPX finally broke out to the downside this past week, and volatility climbed to a four-week high.

SPX weekly price chart
Chart courtesy of StockCharts.com

Speaking of downside, we are in the midst of a historically vulnerable time of year, as well. From a seasonality perspective, October has the worst average drawdown of all 12 months. "Drawdown" is simply the maximum intra-month loss for the SPX, and October averages a drawdown loss of -4.69% over the past 100 years. The key part of this statistic is that while October performance isn't good relative to other months, the average return for October is still positive, and it has a propensity to bounce back after experiencing a pullback.

Given the context of what has happened historically, the weak start to this month isn't a huge surprise, and neither was the mid-week reversal we experienced to end the week. There are some key technical areas that came into play, as well. As you can see in the weekly SPX chart posted above, a trendline connecting the higher lows since the February bottom was supportive during the week, and the index closed back above this level on Friday. In addition, the 2,100-2,125 area acted as resistance for the index on 11 occasions between February 2015 and July 2016. Since breaking above this former level of resistance, the SPX retested the area in September, and has now found support here two times.  

Another thing to keep in mind going forward is that seasonality may not be on our side right now, but things could be looking better right around the corner. November through April is the best six-month period for the stock market over the past 50 years, whereas May through October is the worst (going by average return). Dialing it in a little further, the next couple of months are historically strong, too. November through December is the second-best two-month time frame during the past 50 years, with an average gain of +2.60%.

SPX returns by month last 50 years

From an options perspective, this week will end with the expiration of October-dated options. Peak put open interest remains at the 212 strike on the SPDR S&P 500 ETF Trust (SPY - 213.12), which Todd Salamone highlighted in last week's Monday Morning Outlook. This region held as support last week, and could remain a critical level if we retest the area this week. Any sharp break of this level may create delta-hedge selling, which acts as sharp downside pressure to stocks. On the flip side, with this level in the rearview mirror right now, the open interest configuration is actually rather supportive.

With third-quarter earnings season underway, most analysts are estimating an earnings decline of -2.1% for SPX companies, which would be the sixth consecutive quarter of year-over-year declines. The recent strength in the U.S. dollar could create a bit of a headache for some companies that do a lot of business overseas, which is something to look for in company conference calls. The forward 12-month price/earnings ratio for the SPX is at 16.7, which is higher than the five-year average of 14.9. Obviously, this can revert to the mean in two different ways: a price decline, and/or an earnings improvement.

It's also important to note that the energy sector has been the biggest drag on the SPX since late 2014. This quarter, energy companies are expected to have the highest revenue since late 2014. With oil prices surging recently, and trading near the round-number $50-per-barrel level, the sector could be at a critical juncture during the next two quarters. Given the strong impact energy stocks have had on the broad market, it is something to keep an eye on.

crude futures daily price chart
Chart courtesy of StockCharts.com

Looking ahead to this week's notable events, there are several big names on the earnings docket. Some of the most popular companies set to report are Bank of America (BAC), IBM (IBM), Netflix (NFLX), Goldman Sachs (GS), Intel (INTC), Yahoo! (YHOO), American Express (AXP), Verizon (VZ), Microsoft (MSFT), General Electric (GE), and McDonald's (MCD).  On the economic front, we'll also get industrial production, housing, and inflation data for the month of September. The combination of earnings releases, key economic reports, options expiration, and a pick-up in volatility should make for a very interesting week.

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