Calm Q4 Ahead for Stocks?

ETFguide

As we turn the page on September and enter into the final quarter of the year, there are some major seasonal trends investors should be aware of.

Three statistically positive trends occur around the end of the year. 

First, the annual Santa Claus rally can add significant gains to the market during the holiday season.  Next, November also kicks off the market's "best six months" out of the year.  Finally, October is statistically up by 0.8% on average for the stock market.

Ho, Ho, Ho

According to the Stock Trader's Almanac, the Santa Claus rally officially starts the fifth to final trading day of the year (12/26 this year) and runs through the first two of the new year (01/03/14).  The average market return (VTI - News) during this period is well above average, at 1.5% in only seven days.

The better way to use the indicator, as suggested by the Almanac's editor, Jeff Hirsh, is to "not catch this rally but to use it as an indication for what may happen in the coming year." 

Typically if a Santa Claus rally does occur, the following year will also be positive.  But, if the rally does not happen, it has been a reliable indicator of an upcoming down year.

Buy in October?

Another statistical finding from Hirsch's book is that the money invested in the Dow Jones Industrial Average (DIA - News) since 1950 from November through April has returned an average 7.5%.  Money invested during the other six months of the year has only provided an average yearly gain of 0.3%.

WATCH: Measuring the Market's Mood with the VIX 

An investor who put money to work in equities (IWM - News) just six months out of the year, significantly increased their risk adjusted returns, able to shift into other assets such as bonds (IEF - News) or cash during the worst six months period. 

This strategy is very similar to the popular "Sell in May and go away", and implies indeed selling in May and buying back in late October can be a beneficial strategy.

Historical Anomalies Do Happen

However, as has been the case with September, these are just historical averages and may be meaningless on an individual, year by year, basis.  Over the long run, these strategies may work, but as shown by this September, statistics can be misleading. 

Historically, September is the worst month of the year, down an average 0.6%, but this year it happened to rise significantly, up around 4% thus far.  Are you willing to forgo such gains because over the long run statistically you should have been out of the market (SPY - News)?

Buying stocks in October, because historically it has been a positive month, may want to look at September as a recent example of how trading statistics in isolation can be dangerous.

There are also other reasons to be cautious during this upcoming year.  Just because the end of the year typically provides the best returns, does not mean a major risk off event can't occur.  In fact, other statistics suggest this time frame is indeed the most likely period for a market shock.

Ready for the Volatility?

The table below is one I created of the S&P 500's VIX Index and shows since 1990 the average monthly VIX (^VIX - News) price, monthly maximum price, and monthly standard deviation.

Highlighted in shades of red, the first, second, and third most volatile months based on each respective average VIX price, maximum VIX price, and largest VIX standard deviations are identified

View photo

.

The final three months are the most volatile of the entire year.  The least volatile are not surprisingly the summer months.

Again looking at the table, shown by the fourth column the first standard deviation of the VIX's price for each of the twelve months ranges between $5 and $12, October and November are the only two that reach the upper end double digits. This means that volatility in October and November is the highest of any of the other months.  December is a close third, also well above average volatility.

Noteworthy as well and highlighted in yellow is the average VIX price in October and November.  It also is significantly higher than any other month, at over $22 versus an average closer to $20.  This shows that the monthly volatility is typically skewed toward the upside instead of the downside during these two months and also suggests that October and November have historically provided the most "fear" as a result of the larger pullbacks that have also accompanied them. 

The final three months of the year may be some of the best months for overall investment returns, but these returns come with increased risk of a downside move as well.  This suggests that timing your entries in Oct-Dec is likely more important than the other months due to the increased risk of a market pullback.

Capitalizing on Big Moves 

These VIX opportunities are nothing new to ETFguide's readers.  Numerous times this year we have noticed the market making new highs, but the VIX not making new lows.  In technical terms this is called a "positive divergence" and shows a market rally that is suspect.  Typically, volatility drops as stocks rise, and volatility rises as stocks fall. 

When that doesn't occur, it can help in warning that the market's upside (or downside) is likely limited.  This strategy helped us get long volatility many times this year for some quick profits including this past February which we outlined in our article, "The VIX has Flipped".   

In that research piece, we noted when the VIX was below the 13 level and the stock market was making new 52 week highs, we went long volatility per our subscriber alert on 2/10 in our popular Technical Forecast. We wrote:

"The VIX still looks to be forming a base and given our overall expectations of an eventual market decline and cheap cost of protection, in the money calls remain good for hedging positions." 

Those VIX calls more than doubled as the VIX took off to the 19 level within a few weeks.

With the VIX (VXX - News) again approaching historically low levels and with a statistically volatile October and November around the corner, VIX calls remain a great choice for both portfolio protection and contrarian traders.  A move just to the historical average VIX price of $23 would make VIX calls very profitable.

The ETF Profit Strategy Newsletter identifies specific VIX trades along with other tradable asset classes that offer high probability profit opportunities.  The VIX has again returned to levels associated with volatility lows.  This bottoming area along with the statistical evidence of a volatile next few months means traders should be ready.

Follow us on Twitter @ ETFguide



More From ETFguide.com
View Comments