Stocks were reeling in the wake of a bad report on the U.S. manufacturing sector, which had stoked recession fears.
There was also negative news that corporate stock buybacks were slowing. We had just learned that in the second quarter, the S&P share buybacks number came in at just $160 million. That was about 20% less than the first quarter. It’s also about 20% less than the reading for the second quarter of last year.
Then, on a technical perspective, the Dow had broken below both its 50-day and 100-day moving averages.
At the same time, a study we referenced in the Digest had found that some of the worst starts to October had been followed by huge gains for the remainder of the year.
Given this conflicting information, we turned to John Jagerson of Strategic Trader to make sense of it all.
You see, John is a quant. This just means he uses real, historical market data to identify patterns and trends. Then he uses that information to help make well-informed predictions as to what might happen in the markets going forward.
We asked John to look at historical data and let us know what we might expect in the final quarter of the year.
In short, despite the ugly beginning in October, here was John’s broad takeaway:
Since 1985 the average return of the S&P 500 during the 4th quarter is 4.02% compared to 2.79%, 2.68%, and 0.36% in the first, second, and third quarter respectively …
My advice is to go with the data and make sure you don’t skip the fourth quarter but keep your expectations reasonable.
Here we are a month and a half later, halfway through the quarter, so let’s check in on where we are.
Here’s the S&P’s return since that early-October pullback through Friday morning as I write:
Up nearly 4.5%, which already has us beating historical Q4 average returns — and on a trajectory for even greater gains.
Two days ago, John and Wade updated their Strategic Trader subscribers on the current state of the market, and why traders are appearing bullish … which bodes well for how we’ll close out 2019.
So, in today’s Digest, let’s get their thoughts to see why it looks like a Santa Claus rally is in play.
***Two of John’s and Wade’s favorite charts are suggesting market strength
One of John’s and Wade’s favorite indicators to gauge whether we are in an expansion phase or a contraction phase involves two consumer-based stock sectors: consumer discretionary and consumer staples.
To make sure we’re on the same page, consumer discretionary stocks represent companies like Amazon (AMZN), Home Depot (HD) and McDonald’s (MCD), which tend to do better when consumers have extra money and feel good about their financial situation.
Meanwhile, consumer staples stocks represent companies like Procter & Gamble (PG), The Coca-Cola Company (KO) and Walmart (WMT).
These companies often do well even during economic downturns because people still need shampoo, Cokes, and basic supplies, even when the economy is suffering.
John and Wade explain that these sectors tend to overperform and underperform at certain points in the overall business cycle.
Here’s their chart illustrating this, with commentary below on how to interpret it a bit further:
From John and Wade:
Consumer discretionary stocks typically start to outperform near the bottom of the business cycle, when the economy is shifting from its contraction to its expansion phase.
Consumer staples stocks typically start to outperform near the top of the business cycle, when the economy is shifting from its expansion phase to its contraction phase.
The guys explain that by comparing these two stock sectors, we can see whether Wall Street is preparing for expansion or contraction.
In short when the XLY/XLP relative-strength chart is moving higher, it tells you that XLY is outperforming XLP, and the S&P 500 is likely doing well.
Below is a chart showing this relationship. XLY/XLP is on top, the S&P 500 is on bottom.
Here’s John and Wade on what to look for in it:
The S&P 500 doesn’t always move in lockstep with the XLY/XLP chart, but seeing the XLY/XLP start to move lower can be a good indication that the S&P 500 might start moving lower.
Right now, the XLY/XLP chart is finally starting to form some higher lows. This tells us that trader sentiment is becoming more bullish.
So, it appears trading are gearing up for more gains as 2019 comes to a close.
But this isn’t the only bullish indicator John and Wade are seeing. We can also look toward a traditional measure of market volatility.
***The VIX/VIX3M relative strength chart is also suggesting market strength
When measuring trader sentiment, most investors tend to focus on the CBOE S&P 500 Volatility Index — the VIX. It’s a measurement of the anticipated volatility being priced into S&P 500 options for the next 30 days.
But we can also look beyond 30 days. When traders want a longer-term outlook, they can reference the CBOE S&P 500 3-Month Volatility Index — VIX3M. As its name suggest, it’s a measurement of the anticipated volatility being priced into S&P 500 options for a three-month time frame.
Here’s John and Wade for more:
The value of the VIX3M is usually higher than the value of the VIX because it measures the magnitude of the price movement traders believe the S&P 500 may make for a longer time period.
After all, if you give the market three months to make a move — the time period the VIX3M covers — instead of just one month — the time period the VIX covers — it has a greater chance of making a larger move.
Interestingly, there are times when traders will price in a greater chance of a larger move in the short term than in the long term. Usually, this happens because they are nervous the market is about to drop, and that fear pushes the value of the VIX up higher than the value of the VIX3M.
To examine this relationship, John and Wade created a relative-strength chart of the indexes that divides the value of the VIX by the value of the VIX3M.
Most times, this chart will have a value less than “1.” That’s because the value of the VIX is usually less than the value of the VIX3M.
But during times of fear and market volatility, this reading will be greater than “1” because traders are more fearful about the next 30 days than 3 months out.
Where are we now?
Hardly any fear short-term fear.
The chart below shows this VIX/VIX3M reading at its lowest level since October 2018.
Here’s John and Wade for the takeaway:
… the fact that the VIX/VIX3M is at a 52-week low tells us trader sentiment is extremely bullish.
***The bottom line
Today, we’ve covered two indicators that are suggesting more gains to come in 2019. Now, I will say that my inner contrarian gets a bit nervous when everything seems to be going well.
Markets often tumble when everyone is calling for blue skies and sunshine, which is a bit like where we are now as you can see in the Fear & Greed index below …
That said, if we go by what’s visible to us, the markets look poised to finish 2019 on a high note.
Here’s John and Wade for more:
At the moment, the only thing that looks like it could potentially derail the bullish market sentiment we are experiencing on Wall Street right now is a collapse of the trade talks between the United States and China.
Traders appear quite comfortable with everything else that is happening — the impeachment proceedings, earnings, interest rates and so on.
On the “trade agreement” note, we’re where we’ve been for a while — lots of talk about how close we are, but nothing tangible yet.
On Tuesday, speaking at the Economic Club of New York, Trump said the U.S. and China are close to striking a mini trade agreement, but he didn’t guarantee anything. It was the same optimistic-but-hedging language as usual:
A significant phase-one deal with China could happen — could happen soon. But we will only accept a deal if it’s good for the United States and our workers and our great companies.
But just yesterday, Commerce Secretary Wilbur Ross, confirmed there will be a high-level call today. He added that there’ll be a deal “in all likelihood.”
We’ll continue to monitor this here in the Digest and will let you know. For the time being, it appears happy holidays are on the way.
