Why August Could be One Bear of a Month

Since my last blog post, titled “What I’m Seeing That Has Me Concerned About the Volatility Index” we saw a near 50% rise in the Volatility Index ($VIX) intraday nine days later on June 29th, which caught quite a few traders off-guard. I shared my insight that day in a piece for CNBC, saying the spike in volatility would likely be short-lived. Since then, volatility has resumed its downward path, hitting levels that have rarely, if ever, been seen (depending on which measure of volatility you use). In my VIX post I shared a chart of volatility seasonality, which showed that historically the VIX has put in a low around July/August. To expand on the topic of seasonality I want to dive into equity seasonality for August.

Below we take a look at different viewpoints on market seasonality as well as declining market momentum that could pose as a headwind for U.S. equities.

Seasonality
First up is this monthly seasonal chart by Jon Krinsky, CMT of MKM Partners, as shared by Josh Brown over at The Reformed Broker. Krinsky notes August has averaged a negative decline over the last 30 years but also points out that not every August has been bearish – ’06, ’09, and ’14 were notable exceptions.

Next is a chart I shared on Twitter which is from Tom Thornton’s daily note, Hedge Fund Telemetry. Tom does an excellent job sharing his insights each day in is letter. This chart looks at the decennial pattern of the Dow Jones Industrial Average going back to the early 1900s for years ending in “7”. As you can see, August has been an interesting turning point…. on average for the seventh year of the last 11 decades.

Jeff Hirsch, editor of The Stock Trader’s Almanac, notes that August in a post-election year has not been great for stocks. In fact, it’s the worst month for the Dow and the second worst month for the S&P 500, Nasdaq and Russell 1000 with average declines ranging from -18% to -15%, respective of the index.

Momentum
While discussing U.S. equities we often focus on just the indices themselves, but it’s important to remember that the stock market truly is a market of individual stocks. How those stocks trade is what ultimately impacts the indices themselves. I believe momentum is a powerful tool in stock analysis and can tell us quite a bit on the chart of individual stocks and markets. One such measurement of momentum is the Relative Strength Index (RSI). The chart below shows the average 14-day RSI for each of the stocks that make up the S&P 500. Since March this figure has been in a steady decline of lower highs while the index itself has been grinding higher. What I find really interesting is that we saw something very similar happen during the same time frame last year. In March 2016, the average RSI peaked and began to diverge through August – just before we saw the largest drawdown for that year. Will the same type of price action also follow 2017’s momentum divergence? We’ll see.

Another way to look at momentum is from a lens of being ‘overbought’ or ‘oversold.’ While on a short-term basis being ‘overbought’ can act as a headwind for stocks, it’s often a longer-term bullish sign of strong interest in the stock as buyers push momentum to high levels. By looking at the number of stocks that are seeing a high level of momentum via the RSI indicator we can get a different view of the health of momentum for the overall S&P 500 index. Similar to the chart above, we saw a peak in the percentage of S&P 500 stocks with their respective RSI above 70 (a commonly used level to denote ‘overbought’ status) just above 24%. As the index headed higher fewer and fewer stocks have been able to push their momentum readings above this threshold, with just 6.15% of the S&P 500 stocks getting ‘overbought.’

So there we have it. When looking at the S&P 500, the 50-day Moving Average seems to have become a favorite level of dip-buyers to step up their activity. As of this writing, we are still well above the 50-day as well as the shorter-term, 20-day with the index just a few points off its all-time high. If we do see weakness in equities I’ll be watching the prior June high as well as the 50-day MA as potential support levels. We are still in a well-defined up trend and that shouldn’t be discounted too quickly. There are plenty of catalysts that could keep prices buoyed, but it’s also important to understand the historical market implications and patterns that we also are facing. This should make for an interesting August for sure!

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.

What I’m Seeing That Has Me Concerned About the Volatility Index

I’ve had a great response to my Dow Award paper, Forecasting a Volatility Tsunami, with it being downloaded over 3,000 times since April. I really appreciate the support and the positive feedback I’ve received so far. Last week I had the opportunity to do a webcast with the Market Technicians Association, going into much greater detail about the importance of risk management and shedding some more light on the topic of the paper – low levels of dispersion within the VIX.

What I’m seeing today
As of June 16th (last Friday), the dispersion within the Volatility Index (VIX) (i.e. daily gyrations in in the index) has fallen below the threshold I highlighted in my paper. As I mentioned in my webcast and in the paper itself, I do not believe this ‘trigger’ alone is not enough to generate a final conclusion on the potential direction of the VIX and that in my own research I combine it with several other pieces of data. For example, low levels of dispersion in the Volatility Index is similar to clouds forming in the sky that often precedes rain storms, similar to how low dispersion in the VIX often precedes spikes higher. Just like being able to have dark clouds in the sky without rain, we’ve had periods of time where dispersion has been low for the VIX without it being followed by a spike higher. This is why we must continue our analysis in looking at other pieces of data for confirmation.

While last Friday sent the standard deviation (which is how I chose to measures dispersion) for the VIX to a very low-level, paired with some over factors I follow, has sent up a yellow flag for volatility in my opinion. Below is chart of the VIX with previous instances of what I’m seeing taking place right now. Since 2012 we’ve had this type of trigger occur before several intermediate and large swings within the VIX Index as well as at the end of 2010.  Most recently we saw three occurrences in August of last year before the Volatility Index rose over 70% and major U.S. indices weakened for several weeks.

Seasonality
I find it extremely interesting that this is occurring near the end of June, as based on seasonality, that has been when the Volatility Index has historically bottomed out. Thanks to Callum Thomas for the below chart, which he included in his weekly ‘chart storm’ over the weekend, showing the seasonal patterns for the S&P 500 and the VIX Index since 1990.

This post is not meant to act as a recommendation to buy or sell securities but to show an example of how I have incorporated volatility dispersion within my own research. We’ll see what the VIX does in the coming weeks.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.

What’s In A Name?

“What’s in a name? That which we call a rose
By any other name would smell as sweet.”

Romeo and Juliet

One of my goals for 2017 was to read more. While I’m nowhere close to the Patrick O’Shaughnessy-level of 100+ books a year (Patrick’s book club is a great place to find new titles to read by the way), I am trucking along with my reading list and I’m currently in the middle of reading Pre-Suasion by Robert Cialdini. So far the book has been excellent and is one of my favorite books I’ve read so far this year. While not a finance-related book, there’s one section that stood out that is trading related and helped reinforce something I’ve believed for quite a while.

That is, that many make trading and the evaluation of stocks much more difficult than it truly needs to be. Hours are spent building complex spreadsheets, forecasting cash flows, counting cars in parking lots of retailers, analyzing changes in tone of a CEO during a media interview, etc. Meanwhile, (it’s of my belief that) the market rises and falls on the simple shift of human emotion and psychology which drives supply and demand for a stock. 

That’s where Mr. Cialdini comes in.

Below is a page of Pre-Suasion from a chapter in which Cialdini discusses the idea that people prefer topics and names to be as easy as possible to perform or say. For example, he cites a study that was looked at the names of lawyers and found that those with the hardest names to pronounce were less likely to advance up the ladder of their respective law firms. He also discussed the stock market and the performance of stocks with easy to pronounce names and ticker symbols. 

Seriously! From 1990 through 2004, stocks that had easier to pronounce names outperformed those with unpronounceable names. Now obviously what’s considered easy can vary by the eye mouth of the beholder. But this boils down to the notion that people are drawn to things that are simple – even when it comes to deciding where to invest the trillions of dollars that make up the U.S. financial market.


This is unlike to persuade many of those involved in our field from continuing to expand their spreadsheets with costs of goods sold and revenue projections; nor should it as there is likely value that can be derived from that practice. But it’s important to not lose sight of the idea that at the end of the day, supply and demand within the stock market is largely driven by human emotion. Well what about the HFT traders and all the algos? Sorry to disappoint you but those algorithms were originally written by humans too!

Einstein said “Make things as simple as possible, but not simpler” and he was right. I believe that’s why the concept of long-term trend following has been so effective for so many years. While being one of the simplest ideas of trading (but one of the toughest for investors to stick to), almost binary in its genesis. In fact, AQR showed an example of positive performance of trend following going back to 1880.

This isn’t a post arguing that trend following is superior over other methods or that discounting cash flow is a waste of effort. But to show the simplicity of human desire for the easiest and simplifed solutions, even when it comes to stock selection. At the end of the day basic emotion reins supreme in the search for the easiest route to decision making.

Source: Pre-Suasion: A Revolutionary Way to Influence and Persuade by Robert Cialdini

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.