5 Months Down - Time For A Bounce?
Goodbye September! The S&P 500 is sporting a healthy 10% decline for the year and nearly an 18% drop from the peak. The recommendation to move primarily to cash and fixed income back in April has served us well. So, what about October?
October has been the month that has seen the end of bear markets more often than not. Unfortunately those bear market endings generally consisted of very large declines. The month of October this year is, unfortunately, laden with risks. The government is still engaged in trench warfare which means little assistance from the Whitehouse. The Fed has effectively thrown the towel in at this point with "Operation Twist" which will do little to bolster the economy or the financial markets. The Greece/Europe standoff is quickly coming to a head and Greece will most likely have to default which will put tremendous pressure on the European economy. Europe and China are slowing rapidly and it is a race to see whether it will be the US that drags the world in to a recession or vice versa. As you can see there is more than enough systemic risk to disrupt the markets. Unfortunately, we are going to plaster those systemic risks with a good solid coat of financial risks as the 3rd quarter earnings season kicks off. Analysts estimates remain very high and earnings season could prove to be a disappointment with the slowing of corporate profits combined with a weakening of incomes and a despondent consumer.
First, there have been numerous analysts pointing this fact out lately touting that this is the time to get back into stocks because of the rarity of 5 month negative return periods. However, a look at the data tells us a potentially different story.
If we average each of the 12 months following 5 months of negative declines and look at average monthly returns we find that the better buying opportunity generally comes after a reflex bounce.
This is assuming that September was the bottom.
Which brings me to my second point. What if September wasn't the bottom?
What these analysts don't tell you is what happens if October turns out to be a negative month as well? There have been four 6 month periods of negative returns the markets since 1930. After each 6 month period the market did indeed bounce. Unfortunately, 3 out of 4 times those bounces let to brutal market declines with one of those 6 month periods bouncing before starting a slide into the 9 month long crash of 1974 which still holds the record.
Also, what is interesting is that after 6 months of negative returns a 3 month bounce occurred 3 out of 4 times which turned out to be a suckers rally. The subsequent six months led to negative return and that second bottom, with the exception of 1974, was the better buying opportunity.
With the both a high level of financial and systemic risks in the market today combined with a lack of support from the Federal Reserve, the odds of a strong rebound from these levels looks questionable.
If September turns out to be the bottom of the market then our technical indicators will signal to us a better time to wade cautiously back in to the risk pool. However, if October turns out to be negative then most likely we have much more work to do before a better buying opportunity presents itself.
Finally, if our economic models are correct and we are on the verge of a second recession then stocks do have further downside risk. A reflexive rally is certainly possible BUT should be sold into. This is the first rule of trading during negative market trends as we currently witness today. During an average recessionary bear market stocks decline by 33% on average. As stated previously, with the markets currently down around 18% from the peaks this year, this leaves roughly another painful 20% to go. Of course, I did say "average" recession. In the current economic environment my concern is that the next recession will be anything but "average".