WARNING: Big Correction Ahead

Whether invested during all 12 months of the year or not, there’s no doubt that the large money managers who control most of the cash in the stock market (and therefore control the direction of the market) are well-aware of the seasonality of the market. And if the people who control the direction of the market are aware of these patterns, you should be, too.

The most successful investors don’t stay in the stock market at all times. Instead, they are in only when the probabilities are most in their favor. By following seasonal trends, a variation of technical analysis, you prepare for what you are more likely to see from the market during any given time period.

Not only that, but by understanding the seasonal patterns, you can use the market action to help predict what the market will do in the future. The “Stock Trader’s Almanac,” a stock market guide created by Yale and Jeffrey A. Hirsch, tells us all about the seasonal trends and indications they give us.

So let’s talk about known seasonal patterns and stock market cycles, and the extremely important ways this will affect the market, and your accounts, this year.

Understanding Market Patterns

We know which days of the month are more likely to have the most strength. More often than not, the last few days of the month, the first few days of the month, and even a few days mid-month are the strongest.

This is due to funds that make monthly contributions in the beginning of the month. And, more recently, we’ve seen mid-month strength due to 401(k) contributions on or around “payday” (the 15th).

The market tends to have a bit more strength at the end of the month due to those trying to front-run the “strength investors” identified at the beginning of the month.

I find that the larger the time period, the more reliable the pattern can be. Obviously, the seasonal patterns don’t work like clockwork. These periods of strength or weakness are identified over 40- to 60-year periods. But understanding WHY the patterns exist will help you understand how to use them as indicators.

Basically, when the market shows weakness during certain times (of the year, for example) when the market is typically strong usually means there’s trouble ahead.

We know which months of the year are likely to be the strongest or the weakest. Most people know that November through January are usually the strongest three months of the year. And it might shock you, but February is known as one of the weakest months. For the S&P 500 (SPX), it’s the second-weakest month after September, and the only other month that is down, on average, over the last 60 years.

The Dow Jones Industrials (DJI) and Nasdaq (NASD) have February as a weak month, too, but it ranks in the lower/middle.

The Best 6-8 Months

The best six months of the year for the Dow 30 and the S&P 500 are from Nov. 1 through April 30. (The Nasdaq experiences its “best eight months” from Nov. 1 through June 30.) The results change a bit depending on the time frame that you’re using.

In fact, studies done by “The Stock Trader’s Almanac” show that, since 1950, virtually all of the gains in the S&P 500 have occurred in that six-month period.

The First Month of the Quarter

Because of funds that make scheduled contributions to (investments in) the market on a quarterly basis — and because of those who pay taxes quarterly and view their financial life in quarterly increments who, therefore, add to the market quarterly — the first month of each quarter is often the strongest month of the quarter.

October is viewed by many as the exception, but the reality is, depending on the 20- or 30-year time frame you study, October is often the strongest month of the year.

The 4-Year Election Cycle

One of the most important cycles you can possibly focus on right now is the four-year election cycle.

Why?

Because the weakest year of the four-year cycle is the year we are in right now: the mid-term election year. And this is especially true for Democratic presidencies.

This is what I think about every time I hear traders touting today’s market by talking about the fact that almost all bull markets last into the second year, and often into the third year: The mid-term election year tends to void out most of the known stats like that one.

Recessions and wars tend to begin in the first half of the presidential term (post-election and mid-term). In the last 11 mid-term election years, bear markets either began or were in progress nine times!

This is one of the most heated political arenas we’ve seen in a long time. What we have experienced — heck, what we are experiencing — is being called “The Great Recession.” And this just might spin into another depression, and there’s nothing great about it.

In any given mid-term election year, there is a ton of mud-slinging, positioning and political surprises. Often, we’ll see lots of moves made based on political motives and the politicians will sacrifice what’s in the best interest of the country in order to further their own agendas.

But in this extreme global economic situation, you’d better believe the market is especially vulnerable to a decline.

Look at what happened after the Democrats’ electoral defeat in Massachusetts last week. President Obama adopted a strongly populist tone when announcing new curbs on the banking industry, and that sent the market tumbling.

Get 5 Ways to Profit From the Massachusetts Election

Of course, this was a special election that happened because of Sen. Ted Kennedy’s passing, but that’s just a glimpse of what’s to come throughout this year. Although the move by Obama had been planned for a month, the timing and language used were viewed as a direct response to the Massachusetts defeat.

That was followed by both Democrats and Republicans taking the opportunity to make a populist case against Wall Street and Ben Bernanke just days before his Jan. 31 confirmation, which had a negative impact on the market.

It looks like he will be confirmed, but we still don’t know for sure, and markets hate uncertainty — especially with something as important as that. (Look for a possible market rally after his confirmation).

The point here is it’s very likely we’ll see a sharp correction this year.

Finally, you should know that one extremely accurate seasonal indicator just told us that the market will likely move at least 10% lower before the year ends.

The December Low Indicator

When the Dow closes below its December closing low in the first quarter, as it did on Friday, the market is likely to experience further declines.

Since 1950, the “December Low Indicator” has been 93.5% accurate in forecasting a further stock market decline when the Dow closes below its December closing low during the first quarter. In other words, the lowest close in December is broken in the following (first) quarter.

Since 1950, this occurred 31 times. Out of those 31 instances, the market continued to decline 29 times (on average by 10.9%). In about half of those 31 instances, the market closed higher for the year.

The point is, we should be ready for a sharp sell-off this year.

Get 5 Reasons to Go Short in 2010

‘The January Barometer’

By the end of this week, we will also have the “January Barometer” to work with. In short, “so goes January, so goes the rest of the year.”

So with the December Low Indicator in effect, we may see that signal combined with a negative January Barometer.

According to The Stock Trader’s Almanac, “Every down January since 1950 was followed by a new or continuing bear market, a 10% correction or a flat year. Excluding 1956, down Januaries were followed by substantial declines, averaging minus 14.1%.

“In the 20 years after 1950 — when both the January Barometer was negative and the Dow closed below its December closing low in Q1 of the next year — the Dow suffered additional declines averaging 14.5% from the closing price on the crossing day to the subsequent low.”

Remember in 2008, how the words we heard daily from either the Fed, Congress or the Treasury Department sent the stock market charging strongly in either direction? Well, it’s starting to smell like that once again this year.

Of course, it probably won’t be as severe, and this time around we’ll have a president making major moves along the way. (The younger President Bush seemed to be cleverly hiding in the shadows in the second half of 2008 to avoid hurting the possibility of a new Republican White House.)

What’s important here is that you don’t fight the trends. You must trade with the trends, stay hedged, and don’t be afraid to buy on the large dips. The biggest buying opportunities have been presented during mid-term lows, as the strongest part of the four-year election cycle happens to be the pre-election years … like 2011.

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