Expect the Best for Stocks, But Buy Puts While They're Cheap

The following is a reprint of the market commentary from the December 2014 edition of The Option Advisor, published on November 20. For more information or to subscribe to The Option Advisor, click here.

"May you live in interesting times" goes the old curse -- but please don't take it the wrong way if we observe that it's been an interesting couple of months in the market, to say the least. Both bulls and bears have endured their fair share of jolts, but there have also been some remarkable profit opportunities for longs and shorts alike.

Where to begin with an analysis of the recent action in the S&P 500 Index (SPX)? Well, the Sept. 19 initial public offering (IPO) by Chinese e-commerce giant Alibaba Group (BABA) is a logical place to start, as many pundits predicted the widely hyped IPO would mark a top for the S&P. (A quick Google search for "Alibaba IPO market top" is informative here, yielding north of 5 million results.) In fact, the same day that BABA made its trading debut on the Big Board, the S&P touched a then-record high of 2,019.26.

Of course, as discussed in this space last month, the index proceeded to tumble 9.8%, peak to trough, over the next 18 sessions. While the magnitude of the correction wasn't all that remarkable within the context of a long-term bull market, the sheer speed of the drop sparked panic -- as well as a few victory laps by perma-bears and BABA top-callers.

Those victory laps were a bit premature, though. After bottoming at 1,820.66 on Oct. 15, the S&P spent the final 12 trading days of the month riding the rebound express. The index finished October at a new daily closing high -- and then rang in the month of November by tapping a record intraday peak right out of the gate. For the first time in its history, the S&P went from an all-time high to a six-month low, and then back to an all-time high, in less than two months.

Since then, the S&P has been grinding steadily higher, creating a string of new all-time highs despite a lack of major day-to-day moves. As of this writing, 10-day realized volatility on the S&P stands at 3.03% -- just high enough to confirm the market has a pulse, though the patient appears to have come down with a minor case of exhaustion.

So, where do we go from here? Over a sufficiently long time frame, history tells us that the market will always trend higher -- but, of course, it's the ability to capture the not-quite-so-predictable short-term moves that defines our success as traders. With that in mind, there's good reason to think stocks will continue their steady march higher over the coming weeks.

For starters, there's good old Santa Claus and his reliable rally. The S&P averages a return of 1.5% during the month of December -- second only to April -- and finishes the month higher 74% of the time, going back 50 years. Most of those gains are racked up during the second half of December; the S&P has advanced an average of 1.4% during the last five days of December and the first two days of January (the traditional "Santa Claus rally" period).

Of course, it's fair to theorize that these year-end gains are generated not by St. Nick, but (to a non-trivial extent) by fund managers scrambling to boost their paper performance -- the reliable old "window dressing" tailwind. According to Morningstar data, the average U.S. equity fund was trailing the S&P by more than 5 percentage points, on a year-to-date basis, as of Nov. 19. As fund managers rush to keep pace with the stock market, buying activity by these deep-pocketed players should be a positive catalyst through year-end.

In addition to our regularly scheduled end-of-year programming, it seems the type of "V bottom" the S&P just created may also have bullish implications. Our Senior Quantitative Analyst, Rocky White, ran a study to measure the index's performance following moves similarly dramatic to the one described above. Since 1929, there have been 12 instances where the S&P has touched a 52-week high, pulled back to a two-month low, and -- less than one month after that -- overtook the recent 52-week high again. Following these signals, the S&P has averaged gains that outstrip its "anytime" returns over one-month, three-month, and six-month time frames.

So, while the forecast seems to point to additional upside ahead, the recent S&P whiplash reinforces the notion that it's always wise to expect the best, but prepare for the worst (advice that rings equally true whether you're a perma-bear, perma-bull, or pragmatist). At 13.58, the CBOE Volatility Index (VIX) is currently running at a considerable premium to S&P realized volatility -- but, that said, the VIX is down about 56% from its highs of just over a month ago. As such, now is as good a time as any to pick up portfolio protection, in the form of put options, to both protect your paper profits and guard against any additional shocks over the short term.