As we head into October, there are a few reasons to fear a stock market correction. Atop most minds, of course, is the increasing potential for a shutdown of the U.S. government as Washington fights over the budget and the Affordable Care Act (aka Obamacare).
But looking back at more recent history, the last set of shutdowns had little in the way of a negative effect on the markets, likely because everyone has figured out that the government’s not going to stay out of business for too long. Bottom line is that a shutdown might cause some interim volatility, but no real long-term damage.
Volatility is no stranger to October, as it’s typically the month that sees the largest change in volatility. A number of reasons share the blame for the spike in volatility in the market, including Q3 earnings season (set to kick off on Oct. 9) along with the return of trading volume after the slow summer months.
While the month is historically one of the most volatile months of the year, we also refer to it as the “Cardiac Kid” in terms of comebacks. That’s because the selloffs that occur during October are often met by strong buying, as investors have come to expect the October selloff to be the gateway to the end-of-year rally.
Looking at the numbers, October averages a monthly return of +1.3%. Comparing it to the other 12 months of the year, October is among the stronger months for average returns and average winning percentage. From a strictly numbers perspective, the month is a consistent performer, despite the usual spike in volatility.
In addition to the positively biased October seasonality, the market is providing a number of reasons to believe this October could kick off another strong Q4. Referring to the table above, the months of November and December represent another two seasonally strong months. This performance is often the result of money moving back into equities from the sidelines as portfolio managers chase returns into the year-end.
Here’s how we think it could play out:
Click to Enlarge The accompanying chart shows that the market is in the process of selling off from an overbought signal that occurred as the S&P 500 hit its highs around 1,725. We’re expecting to see the market continue lower, breaching its 50-day moving average in early October trading as the wrangling over the budget, Obamacare and the debt ceiling offer a reason for traders to lock in profits.
The S&P 500 should see some technical buying at the 1,660 mark as traders key in on the 100-day moving average — a technical trendline that held stocks in August. This is the point that it likely will pay to start adding exposure to stocks in preparation for an end-of-year rally.
Click to Enlarge Aggressive investors may choose to profit from the seasonal increase in volatility by buying the iPath S&P 500 VIX Short-Term Futures (VXX), which provides a good hedging opportunity for traders. The VIX is known as the “fear gauge” of the market. This barometer of market volatility moves higher as the S&P 500 declines or sees an increase in volatility. Those well-versed in the ways of the VIX know that it tends to spike sharply when the market moves lower.
Our current target for the VXX is for another 20% increase during the month of October, with a target of $17. Our call on the VXX in late August played out within 16 cents of our target under similar trading circumstances.
Click to Enlarge Similar to our August call on the market, the ProShares UltraShort S&P500 (SDS) shares are an attractive trade to benefit from some short-term market weakness. These shares move inversely to the S&P 500 at a 2:1 ratio, meaning that the ETF theoretically will go up about 2% for every 1% decline in the S&P 500.
Our short-term target for SDS shares matches our July 28 target of $38.75 — a move of about 7%.
As of this writing, Johnson Research Group did not hold a position in any of the aforementioned securities.