3 Ways to Trade for October Seasonality

by Johnson Research Group | September 28, 2012 11:21 am

The market has done an amazing job of bucking the seasonal summer trends this year by posting strong monthly results for August and September, two historically weaker months. Some view the divergence from the usual weak summer performance as the result of the presidential election. General election years often see rallies through July and August, disagreeing with normal seasonality trends.

The “normal” and election-year seasonality trends agree, though, that the month of October is likely to introduce volatility back into the market. All the way back to 1990, the month of October has typically been the month that sees the largest change in volatility. A number of reasons share the blame for this spike, including the Q3 earnings season (set to kick off on Oct. 9) and the return of trading volume after the slow summer months.

On top of that, October is also a month for comebacks. The selloffs that occur during October are often met by strong buying as investors have come to expect them to be the gateway to the end-of-year rally.

Looking at the numbers, October averages a monthly return of +1.5%. Comparing it to the other 12 months of the year, October is the solid third-place winner for average returns and average winning percentage. From a strictly numbers perspective, the month is a consistent performer.

In addition to the positively biased October seasonality, the market is providing a number of reasons to believe that this October could kick-off another strong Q4. First, there’s sideline money. According to a number of sources, the amount of sideline cash available to money managers has swelled as the “crowd” continues to wait for a monumental pullback in stocks.

Since some of the more devastating risks (a crumbling eurzone, no U.S. stimulus) have been averted, the market appears ready to continue climbing its “wall of worry” after a short correction.

So how do we see this playing out?

Given the chart of the S&P 500, the market has room for a short-term correction back to the 1,400 level. This would be roughly a 5% decline from recent highs — enough to allow investors to feel like stocks are “on sale” and thus present an opportunity to those late to the party to start buying in before things take off again.

If history is any indication, this pullback will likely last for the first week or two of October, just as earning season begins to fire up. After that, the market should start seeing a bid for stocks as investors anticipate another strong Q4, regardless of the outcome of the election in November.

With that in mind, here are three funds for October seasonality:

iPath S&P 500 VIX ST Futures ETN

Given the likelihood of a pullback, we still like the idea of hedging the market risks through the use of the iPath S&P 500 VIX ST Futures ETN (NYSE:VXX[1]). This fund allows investors to benefit from increases in volatility as if you were long the CBOE Volatility Index (NYSE:VIX[2]).

The shares are trading around $9 right now, which represents some of the lowest prices of the year. If the market does hit a volatility spell, this position will help offset potential losses in other positions.


As for after the volatility storm, we like consumer discretionary and retail ETFs as long positions through the year’s end.

Since the year-end shopping season is almost upon us and with consumer sentiment improving there’s a good chance that the retailers will see a good year, SPDR S&P Retail ETF (NYSE:XRT[3]) is a good pick. There have been some signs of pessimism towards the ETF, as short sellers have been holding XRT shares to the tune of an interest ratio of nearly 7.

Still, the XRT is up more than 20% against the S&P 500’s 14%, meaning that the sideline money will be chomping at the bit to take positions here before year-end. We’re targeting a move above $70 by year-end.

Consumer Discretionary SPDR ETF 

Like the retail sector, discretionary stocks are trading 20% higher for the year as improvements in the economy, ever so slight, have helped consumers open their wallets. A good play is the Consumer Discretionary Select Sector SPDR (NYSE:XLY[4]). A similarly pessimistic backdrop is in place for the discretionary sector, signaling that these stacks are far from “overbought” and ripe for another run higher and a target of more than $50 by year-end.

As of this writing, Chris Johnson did not own a position in any of the aforementioned securities.

  1. VXX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXX
  2. VIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VIX
  3. XRT: http://studio-5.financialcontent.com/investplace/quote?Symbol=XRT
  4. XLY: http://studio-5.financialcontent.com/investplace/quote?Symbol=XLY

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