Seasonality May Not Play Out as Expected

Sentiment indicators suggest there could be more money on the sidelines

CMT, Senior Market Strategist
Aug 13, 2018 at 8:38 AM
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With the better part of earnings season winding down this past week, we head into the summer doldrums of August -- a notorious period in the market for volatility spikes when volume tends to dry up. Financial media has been highlighting this seasonally tough period and the current geopolitical risks for the last few weeks in anticipation, but the stock market kept marching higher in the face of headlines on the back of great earnings reports. According to FactSet, so far, the companies in the S&P 500 Index (SPX - 2,833.28) are reporting 24.6% growth in Q2 2018, which would be the second-highest earnings growth since Q3 2010. 

Judging by last week's market action, pundits will point to the S&P 500 reversal on Friday that erased all weekly gains as a potential indicator for a further pullback. The SPX traded in a narrow range mid-week and hovered near 2,865, a dual resistance area, which was identifiable as the index rode the top of a trend channel that formed from the triangle breakout in early May. With the all-time closing high only a chip-shot away at 2,872.87, this area of resistance proved to have plenty of overhead supply. 

SPX daily chart MMO Aug 13

Also, it's rare to go straight through all-time-highs without consolidations, justifying a pullback. New geopolitical issues -- the Turkey crisis -- happened to be the perfect excuse for a quick gap down Friday. Although, tariffs issued by the Trump administration last week and the ongoing currency crisis in Turkey's economy should have relatively little effect on the U.S. markets. Note, Turkey is only the 18th largest nation by gross domestic product (GDP), and ranked 31st among the United States' top trade partners.

While the S&P 500 was negative on the week, the Nasdaq Composite (IXIC - 7,839.11) and Russell 2000 Index (RUT - 1,686.80) were able to finish positive, but both indexes were unable to get through round-number resistance areas. The Nasdaq stalled at the 15% year-to-date (YTD) mark, while the Russell hasn't been able to make it through the 10% YTD level during the past two months. The Invesco QQQ Trust (QQQ - 180.52) is searching for support at the 180 level, after pushing through prior resistance and 50% above the 2000 peak earlier in the week. As we mentioned last week, the S&P Mid Cap 400 Index (MID - 1,996.02) is also searching for support near the round-number level of 2,000, after breaking above this area mid-week. 

As for the U.S. economy this past week, the market received few economic updates, with jobless claims, the consumer price index (CPI), and U.S. Department of Agriculture (USDA) crop reports being the only potential market movers. The CPI gained 0.17% for July, which was in line with estimates, and jobless claims came in slightly better than expected. However, the USDA crop reports were negative Friday, as expected, and we saw pressure in the respective commodity markets, which could have added negative pressure to Friday's sell-off.

The market is searching for slumping economic data points, but so far nothing has suggested that a recession is in the near-term future other than the fear of a flattening yield curve. However, we know a flattening yield curve can last longer than most expect and is overblown as a short-term indicator, like I mentioned the other week. 

"This August has been remarkably calm for the stock market, but history suggests it may not last."
-- The Wall Street Journal (subscription required), August 10, 2018

Without slumping economic data points, financial strategists and pundits have relied on seasonality as a potential catalyst for a sell-off. Indeed, August can often be the start of seasonal corrections for the broader markets. That's a fact when you look at the data over the last two decades, but that doesn't mean we're necessarily due for an imminent correction as some have suggested, or that we'll finish negative for the month. 

According to Reuters data, August is the second-worst month on average, dropping 0.33% monthly -- behind only September's average monthly loss of 0.40% -- during the last two decades. When you increase or decrease this time frame, these conclusions can change drastically. 

Taking a longer-term view, we find that August has a positive average monthly return of 0.55% when going back to 1928, and September is by far the worst month, with an average monthly loss of 1.00%. Now, looking at the past decade, August has generated a loss of 0.70%, on average, while September is positive by 0.76% -- a surprising revelation. The point I want readers to take away is, returns vary throughout time. 

When analyzing these seasonal trends and patterns, I found that over the last decade, when the first five trading days in August were positive, except for 2010, the month ended positively. Conversely, when the first five trading days of August were negative, the month ended negatively every time. Thus, this seasonal analysis has some statistical significance, since the prevailing trend has been correct nine times out of 10. 

 "As we mentioned back in June, the month after Fed hikes, the SPY has had a median return of negative 0.42%. This played into our short-term outlook for the last four weeks, but that timeframe is now behind us. According to Reuters data, market participants are currently pricing in a 2.6% chance that the Fed will raise rates on Aug. 1. This could be a potentially bullish catalyst for markets, especially if we are close to testing all-time highs, because the SPY median return after the Fed holds rates is 1.77%."
-- Monday Morning Outlook, July 16, 2018

Devoted readers are also aware that during the current rate-tightening cycle, equity markets have underperformed or experienced a drawdown in the month following a rate hike, while showing a tendency to rally when the Fed holds steady. With both analyses being favorable for August, we could see a positive month, which is contrarian to the broader media news cycle.

"One scenario is that this caution represents buying power in the immediate days ahead, especially with the SPX trading around multi-month highs on the heels of the Fed's 'pause' last week. Another potential scenario is the strategists being correct about the risks, but early on the timing. With an expected rate hike at the September FOMC meeting, which will likely coincide with a ramp-up in midterm election uncertainty, perhaps their case for a pullback becomes stronger roughly six weeks from now."
-- Monday Morning Outlook, August 6, 2018

Sentiment has remained tempered as many market participants have mixed-to-negative views, which further complements a potential bullish scenario for August. In the most recent weekly American Association of Individual Investors (AAII) survey, bullish sentiment increased by 7.3 percentage points, but still isn't even at the historical average of 38.3%, suggesting that retail money remains on the sidelines. Meanwhile, the 10-day equity-only, buy-to-open put/call volume ratio rose again last week and appears to be finding a bottom above 0.60, which last week we mentioned preceded a spring rally. 

Contrary to the above indicators is the Cboe Volatility Index (VIX - 13.16) 20-day buy-to-open call/put volume ratio, which moved to 5.55 and is the most elevated reading since mid-July 2017. We recently highlighted that this could be a red flag for investors. In addition, the VIX hit a low of 10.17 intraday last Thursday. Meanwhile, the Commitment of Traders (CoT) data showed large speculators were net short VIX futures by the most since December. Moving forward, we will keep this on our radar since large speculators have been caught flat-footed ahead of every significant VIX move since 2014.

CoT VIX MMO Aug 13


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