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Seasonal Pattern is Not Helpful (for bulls)

Thursday, June 17th, 2004  10:15pm EST

Void of Seasonal Positives

Bottom Line:  Various ways of determining seasonal biases show that when there are several positives lined up at once, those days tend to outperform days when there are none.

It has been noted often that we are now in the summer doldrums, a time of year when the market shows malaise and overall has a relatively negative bias (thus the phrase “sell in May and go away”).  While that didn’t do well last year, and during Presidential election years it may be a different story, as I showed in February, generally the summer months lack the kind of positive seasonality that provides a gentle breeze at the backs of bulls during other times.

Something that I post to the site each day on the Daily Overview page is called the Seasonality Index (it’s towards the bottom of the page).  Created by Jay Kaeppel, this Index gives a point for each positive bias that a day may have.  According to Mr. Kaeppel, there are four consistent seasonal biases to track:

1.  The two days immediately prior to an exchange holiday (New Year's Day, Presidents' Day, Easter, Memorial Day, July 4th, Labor Day, Thanksgiving and Christmas).

2.  The last trading day of the month and the first four trading days of the next month.

3.  November 1st through the 3rd trading day in May.

4.  The most favorable 14 months of the 48-month Presidential election cycle.  This begins on October 1st two years prior to each Presidential election, and ends on December 31st of the following year.

Each bias gets a score of 1, so on a day when there are none of these biases present, your total score would be “0”, and on one of those rare days when all four are present, you would get a “4”.  Mr. Kaeppel tested this system on the Nasdaq from 1972 - 2002 and found that readings of +2 or greater outperformed non-seasonal days by a significant degree.  He also found that readings of 0 under-performed all nonzero days by a likewise significant degree.

I have been intrigued by this work for some time, and finally got a chance to look at it myself this afternoon.  The table below uses the S&P 500 from 1950 through today, and shows the market’s performance for days with each of the four possible total scores.

We can see from the table that on a day when none of the four seasonal biases are present, the S&P actually showed a negative average return, and was positive on almost exactly 50% of the 3,604 days.  As we notched more biases in our favor, the S&P’s performance improved, slightly at first and then dramatically.  By the time we had 3 out of the 4 biases present on a given day, the S&P showed an impressive average return of 0.23%, with 62% of the days being positive.  Those rare “4” days, when all biases were present, also gave an impressive performance, with even more of the days being positive.

This is where it gets interesting.

Let’s say that in 1950, you had $10,000 to trade and decided to buy the S&P 500 at every open and sell it at every close, using all your money.  Your $10,000 would have grown into just under $2 million by now.  Now let’s say that when a “0” day arrived, you decided to stay in cash and not trade that day.  Interestingly enough, even though you were in the market only 74% of the time, your $10,000 would have still grown into just under $2 million.  Now let’s make it really interesting…when you saw a “0” day, you still went to cash, but if it was a “3” or “4” day, then you decided to play the odds and you leveraged your bets 2-to-1.  In that case, your $10,000 initial stake would have grown into more than $13 million, a return of over 133,000%.

PLEASE NOTE that this is NOT a trading system.  I have made no adjustments for dividends, slippage, commissions, interest on cash balances, etc.  Also, for the open price I used yesterday’s closing price, so gap opens are not accounted for – not that it matters, since it wasn’t really even possible to trade the S&P 500 itself until the futures market came along in the early 1980’s. 

Let’s look at this data one last way.  By looking a bit into the future and summing up the total number of points that we will be seeing over the next month, we can get an idea for how positive or negative the market may be.  For example, as of today the summed score over the next 21 days is 7, which includes the positives of month-end as well as the July 4^th holiday.  It turns out that 7 is a fairly low score, and the market certainly doesn’t do as well as when the score is higher.  Whenever this summed score was 10 or less, the S&P showed an average gain of 0.1% 20 days later (with 55% of the instances being positive), but when the summed score was 50 or higher, then the return jumped to 2.2% (with 77% of the instances being positive).  The table below outlines these results:

We can see that even out over the next six months to a year, those times when the summed score was very high dramatically outperformed those times with low scores.  The chart below puts this summed score in graphical format:

My point in presenting this exercise is to show the potential value of keeping track of when the market may have an added wind to its back by some of these seasonal influences.  By watching when the market may or may not have a positive bent to it, we can adjust our expectations accordingly.  While it is difficult to implement this type of information in practice, I do suggest that especially shorter-term traders watch the Seasonality Index daily, and when we get a “3” or “4” day, it probably pays to be more aggressive than usual on the long side.  It would be foolhardy to suggest going short on “0” days, but I do think it is probably more difficult to make money on the long side on those days than others.  Somewhat discouragingly, we will not have another “3” day until December 31^st of this year, and not another “4” day until sometime in 2006 or 2007.  Longer-term traders may want to keep track of what the upcoming month may hold as far as these scores go, and when they begin to add up, it can pay to be more aggressive on the long side.

Lack of (open) Interest

Bottom Line:  Open interest in OEX call options fell yesterday, marking one of the few times this occurs.  If we see more of this type of activity, it often precedes market weakness.

On May 18^th, I noted that OEX traders had been decreasing their open interest in put options.  Decreasing open interest means that more of the volume during the day was used to close existing contracts than was used to open new ones.  This is an unusual occurrence, and at the time I showed how a reduction in put open interest normally lead to a positive market.  Now, we have something of an opposite situation, as these traders reduced the open interest in call contracts on Wednesday, the first time that has happened since early April (outside of expiration).

It stands to reason that if a reduction in put open interest tends to be bullish, then a reduction in call open interest tends to be bearish.  While the correlation isn’t as strong, overall it does hold to be true.  90 days after call open interest declined at least twice within 10 days, the S&P was higher only 28% of the time (29 times out of 104 occurrences) with an average return of -4.3%.  Contrast that to any time put open interest declined at least twice in 10 days – 90 days later the S&P was higher 67% of the time (52 out of 78 occurrences) with an average return of +3.0%.  While one day of declining call open interest doesn’t seem to be a big deal, we should continue to watch this data, especially after expiration, to see if it marks the beginning of a trend.

Conclusion 

Many have been pointing out the low volume of the past couple of weeks, and in fact that “problem” may be even worse than suggested.  Over the past few weeks, program trading, which I discussed a couple of weeks ago, has averaged more than 52% of total NYSE volume.  If we look at just non-program volume, last week and the week before saw two of the lowest-volume weeks in four years, other than the holiday-influenced weeks around the beginning of this year.  To see lower volume, we would have to go back to September 2000. 

Somewhat related to the paragraph above, our SPY and QQQ Liquidity Premiums are now down to extreme territory.  This tells us that there has been an utter lack of demand for the features that ETFs provide in times of uncertainty.  Perhaps this is an indication that investors are comfortable with their individual stock holdings, and from the history we have of this data, it is not a positive indication for the market in general going forward.  Click here to see the charts, or use the Chart Quick Pick feature. 

Today was a fairly typical reaction after such a tight-range day as Wednesday was, and which I mentioned in the intraday notes.  Our shortest-term measures continue to wallow around in neutral territory, and they still show no clear edge in either direction.  While there may be some intraday opportunities that pop up, as of today our indicators are not giving us a chance to define a high-odds, low-risk setup. 

Longer-term, I will just repeat what I said this weekend as it continues to be my view…May saw an important intermediate-term low, declines that put us into an oversold situation should be viewed as opportunities to add or initiate long exposure, we should see modest gains for the year, but the best strategy will most likely take advantage of oscillating indicators (selling overbought conditions and buying oversold ones) rather than breakout strategies.  The closer we are to the top of the trading range, the less inclined I am to be holding long positions.

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

Disclosure:  no positions

This disclosure is not intended as trading advice in any form.  It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary.  Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook.  Positions can and do change at any time, without notice to the reader.

© 2004 Sundial Capital Research, Inc.  All Rights Reserved.