Reasons to Stay Bearish

2016 is proving to be anything but boring so far. U.S equity markets rang in the new year with a significant sell-off that has left the S&P 500 roughly 10% off its highs. This recent volatility has many debating whether we are experiencing a mere market correction within a long-term bull market or the end of the bull market. Is this the beginning of a cyclical bear market for stocks? Based on the technicals and current market conditions I have a bearish, risk-off outlook and personally have been taking more short positions than I ever have in the past.

The Bull Market is Getting Old

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Perhaps one of the most basic arguments favoring the bears is the average longevity of a bull market.  The data I am looking at comes from an analysis done by Mackenzie Investments (pictured above) that examined bull and bear market periods of the S&P 500 index dating back to 1956. The report shows that bull markets last an average of 4.3 years (51 months) and in that time gain an average of 153%. The current bull market has lasted almost 7 years now (83 months) and returned 206% (2016 not included.) It’s important to note that there’s much discrepancy in how analysts measure and define a bull market, but no matter how you look at it, it’s clear that the bull market investors have enjoyed since 2009, is getting long in the tooth and a cyclical bear market may be on the horizon.

The Technicals

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In my opinion, the most compelling argument favoring the bears lies in the long-term charts of the major U.S. indices.

Above is a 20 year chart of SPY, a popular ETF that tracks the S&P 500 index. A solid resistance level was formed in 2008 when the index failed to breakout above the high’s from the year 2000. The index was able to breakout above this level in 2013 and has since extended well above. Typically when price breaks out above a resistance level, this former resistance level then acts as support when price revisits it. I expect the 140-160 level that served as resistance in ‘00 and ‘08 will act as a trampoline of support once it’s tested. Unfortunately for the bulls the S&P will need to fall roughly another 20% until it reaches this key level. For anyone interested in Fibonacci patterns, one of my favorite technicians, J.C. Parets has been very vocal in pointing out that in 2015 the market reached the 161.8% fibonacci extension of the ‘07-’09 decline (In red above). He explains the importance of the 161.8% fibonacci extension in his post “Is This Why The S&P500 Stopped Going Up?”

 

Seasonality

The January Barometer is one of the most basic concepts in the study of seasonality. It states that as the S&P 500 goes in January, so goes the rest of the year. Since 1950 this indicator has accurately predicted the direction of the market 87.7% of the time! For example in January 2000 the S&P fell 5.1% and finished the year -10%. In addition, in January 2008 the S&P fell 6.1% and finished the year down 38.5%. In January of this year the S&P fell 3.4% which suggests more pain for the rest of 2016. Furthermore, Santa was a no show this year for investors expecting the famous “Santa Claus rally.” The Santa Clause rally is the tendency for stocks to rally in the last 5 trading days in December and the first 2 in January. In the past, the absence of such a rally during this period has been known to be a predictor of bear markets.

The volatility we’ve seen recently in equities is an indication of the level of uncertainty that exists among market participants. In these times of uncertainty it’s important to tune out the noisemakers and financial news media and trust only price action and historical data. Long-term charts and data show us that we may be due for a bear market and seasonality indicators suggest more pain ahead for 2016. Some financial pundits are saying this 10% decline is nothing more than a great buying opportunity, but it is important to keep in mind the presence of bearish conditions that have the potential of turning a “correction” into a recession.

As always, feel free to email me with any questions or comments Pdunuwila@gmail.com

An Introduction to Seasonality & Stock Market Cyclicality

Seasonality is a term that refers to the recurring tendency of the stock market’s performance to behave in a pattern according to the time of year, day of the month or other cyclical occurrences such as presidential cycles. Understanding seasonal patterns and cycles that influence the markets can allow you to increase your odds of success. Take for example the old adage “Sell in May and Go Away”, not only does it roll right off the tongue, it is a time tested strategy based on the stock market’s monthly performance averaged over many years. In addition to this strategy I will be discussing some other influential seasonality patterns and how to profit from them.

It’s important for me to note that history doesn’t repeat itself exactly. Skeptics will point out that markets do not conform to these patterns 100% of the time, however historical data shows us that market fluctuations very frequently do follow predictable patterns. It is pretty hard to argue with statistics.

“Sell in May & Go Away” (Best 6 months switching strategy)

This is a well known strategy based on monthly historical data revealing the tendency for the market to perform stronger on average between the months of  November and April and weaker between May and October. The strategy therefore would be to either be underweight or completely out of equities during the “worst 6 months” and overweight or fully invested in the “best 6 months.” Academics largely ignore this strategy as it goes against the efficient-market hypothesis. However, when you back test this strategy, it is hard to ignore that it is quite profitable.

The chart below is from Stock Trader's Almanac, the bible for seasonality. It shows that if you were to invest $10,000 in the Dow Jones during only the "worst 6 months" beginning in 1950 you would now have lost $6,500 as opposed to investing during the "best 6 months" in which case you would have a current total of $2.3 million. Even when compared to the simple buy & hold strategy, the returns that result from the "best 6 months" strategy are undeniably better.

The chart below is from Stock Trader’s Almanac, the bible for seasonality. It shows that if you were to invest $10,000 in the Dow Jones during only the “worst 6 months” beginning in 1950 you would now have lost $6,500 as opposed to investing during the “best 6 months” in which case you would have a current total of $2.3 million. Even when compared to the simple buy & hold strategy, the returns that result from the “best 6 months” strategy are undeniably better.

January Indicators

There are several key indicators to watch for in January that really set the stage for the rest of the year. 

The January Effect 

Investment banker, Sidney Wachtel, coined this phrase “January Effect” to describe the tendency of small cap stocks to outperform large cap stocks in the first month of the year. This effect is likely due to end of the year tax-selling that drives down the price of small-cap stocks making them cheap and undervalued at the beginning of the new year. The “Free Lunch” strategy is used to capitalize on this tendency. In this strategy you buy beaten down small cap stocks at the end of December and sell in February, taking advantage of the January effect. 

The January Barometer

The January Barometer describes the predictive nature of the month of January. The belief is that January’s return (positive or negative) is a good indication of the rest of the year’s performance. Since 1950 this indicator has accurately predicted the direction of the market 88.9% of the time. For example, if January is positive there is a strong chance that the rest of the year will also be positive. This tendency has largely been attributed to congress reconvening in the first week in January including the newly elected members of congress. In addition the President gives the state of the union address outlining goals and laying out the annual budget.

Santa Claus Rally 

The Santa Clause Rally is the tendency for stocks to rally between Christmas and the New Year. There are plenty of theories that try and explain this phenomenon, including people buying to take advantage of the lift of the “January effect.” The absence of a Santa Claus Rally can be a warning flag for the year to come. For example at the end of 2007 the Santa Claus rally period had a negative return of -2.5% What followed in 2008 was the worst stock market decline since the great depression. Furthermore, in 1999 the market had a negative return of -4% during the Santa Claus period. This was followed by the burst of the tech bubble in the next year which sent stocks tumbling.

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(Chart Source: Humble Student of the Markets)

Presidential Cycles

The presidential election cycle has a statistically significant influence on the market. Take a look at the two charts below and you will notice that the 3rd year of a president’s term has historically been the best performing year. In the third year the market has returned an average of 18% and has been positive 94% of the time since 1946! To take advantage of this pattern it would be advisable to be overweight equities in the third year and underweight in the weaker years of the presidential cycle.

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One of the explanations for this tendency is that the third year is also the pre-election year, in which a president will go to great lengths to get re-elected. While in office a sitting president will try and manage the economy in a manner that will set the stage for good economic times leading up to the election.

While these patterns and cycles are averages and won’t always play out exactly as they did in previous years, over the long run taking advantage of these seasonal and cyclical market anomalies may help you to reduce risk and profit from uncertain markets.