October Could Spook the Stock Market

After the bulls in late August stepped in to save the month, they continued running with the ball throughout the month of September, leading the broader U.S. equity indices to closer higher for another month. While the trend undoubtedly remains higher, market internals have slowly been waning and more concerningly, market volatility has literally crashed as investors seem to be on a complacency high.

The saying goes that “it’s calmest right before the storm” and considering what’s at stake this month of October, this could indeed be a good thing to keep in mind, all the while respecting the broader up-trends as long as they remain unbroken.

And so as the foliage piles rise at an accelerating rate, today we enter a fresh month and the last quarter for 2017 for the financial markets. The home-stretch quarter often makes or breaks any given portfolio manager’s and individual investor’s year if prudent risk management is not applied. As such the seasonal patterns will need to be kept in mind, which for the month of October usually signal at least one spike in volatility and push lower for stock prices.

While the catalysts for October stock market volatility are different each year (history doesn’t repeat but often rhymes), the aforementioned strong seasonal tendency must be kept in mind.

My top four risks for this month of October (in no specific order):

The Federal Reserve will begin shrinking its $4.5 trillion balance sheet. Although the balance sheet reduction will take place in baby steps, in the past when the Federal Reserve removed part of stimulus, stocks didn’t like it too much in the near-term.
Corporate earnings season will kick off in earnest the second week of October
The aforementioned tendency for a seasonal volatility spike for stocks in the month of October
U.S. tax overhaul — should clearer signs emerge that the tax package cannot pass or must pass in a much smaller format, stocks may not like that much either.

Stock Market Charts

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Moving averages legend: red – 200 day, blue – 100 day, yellow – 50 day

On the charts, we see that the S&P 500, or the S&P 500’s SPDR S&P 500 ETF Trust (NYSEARCA:SPY) continue pushing higher in an ever more narrow manner and as a result of last month’s rally are once again hugging the very upper end of this up-sloping triangle formation.

Meanwhile momentum as represented by the MACD momentum oscillator at the bottom of the chart last month failed to make a higher high and rather printed a lower high versus the momentum high earlier in the year. To be clear, none of these are yet signals to sell all and head for cover, but prudent risk management at this stage in the cycle does dictate taking both near and intermediate term risk exposure down.

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Moving averages legend: red – 200-day, blue – 100-day, yellow – 50-day

Meanwhile, small capitalization stocks, i.e. the Russell 2000 or the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) as a result of last month’s rally have blasted above their longer-standing line of resistance as implied volatility in the index dipped to fresh long-term lows.

From a reward-to-risk perspective, in my eye this current juncture represents an awful spot to add risk but a good spot to reduce risk positions (stocks and other risk assets) and/or to put on some portfolio hedges.

Conclusion

In conclusion, while price is the ultimate arbiter and price as represented on the above charts continues to press higher, warning signs of a 5%-10% pullback in stocks in the near-term are abundant.

Again, unless stock prices actually begin to reverse lower, these are just warning signs, but prudent risk management does dictate to take profits along the way, particularly when we reach extremes as we have in stocks in the month of September.

Check out Serge’s Trade of the Day for Oct. 2.