October can be a scary month if you’re a superstitious stock trader. Here’s why…
On Oct. 29, 1929, the stock market crashed on Black Tuesday and ushered in the Great Depression.
Not to be outdone, on Oct. 19, 1987, the stock market crashed again on Black Monday, wiping out more than 20% of the market’s value in a single day.
Nervous yet? Do you have your lucky rabbit’s foot handy, just in case?
Well, we don’t think you’re going to need it this year because the stock market appears to be doing just fine on its own.
You see, there’s nothing magical, or cursed, about October. It’s all quite natural really. Big movements — both bullish and bearish — tend to occur when a lot is going on in the world, and October happens to be a month where a lot of important things can happen.
For instance, every four years, investors look for an October surprise in the U.S. presidential election. Plus, third-quarter earnings season kicks off in October, and earnings season always has the potential of ratcheting up market volatility.
So what about this October?
Everything we are seeing right now tells us that bullish investors are willing to give the stock market the benefit of the doubt for now.
The first thing we’re seeing is a strong, up-trending channel on the S&P 500.
Looking at the daily chart of the index in Fig. 1, you can see that while the S&P 500 has experienced a recent pullback, it has not broken below the longer-term up-trending support level that forms the bottom of the channel it has been in since recovering from its bearish correction in April.
The bullish bounce up off a confluence of support levels — both up-trending and horizontal — just above 3,200 confirms that the level that served as resistance before the S&P 500’s bearish pullback in June is now holding as support in the aftermath of the index’s bearish pullback in September.
Plus, the S&P 500 is still well above its 200-day simple moving average, telling us the index’s longer-term bullish momentum is still intact.
XLY/XLP Relative Strength Chart
One of our favorite methods to gauge whether bullish sentiment is getting stronger or is starting to fade is to create a relative strength chart comparing the two consumer-based stock sectors against each other: consumer discretionary and consumer staples.
This method is especially useful during this period of coronavirus-driven uncertainty.
Consumer discretionary stocks represent companies that tend to do better when consumers have extra money to spend and enough confidence in their economic future to spend it. Think of companies like Amazon (NASDAQ:AMZN), Home Depot (NYSE:HD) and McDonald’s (NYSE:MCD).
Consumer staples stocks represent companies that tend to do well even during economic downturns. Think of companies like Procter & Gamble (NYSE:PG), Coca-Cola Company (NYSE:KO) and Wal-Mart (NYSE:WMT). These companies do well because people tend to continue buying shampoo, Coke and general supplies even when the economy stinks.
As you can see in Fig. 2 — a chart that shows which stock sectors tend to outperform during various stages of the business cycle — consumer discretionary (Stage 2) and consumer staples (Stage 5) are at opposite ends of the cycle.
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.
By comparing these two stock sectors, we can see whether Wall Street is preparing for continued expansion or continued contraction.
An Important Comparison
When consumer discretionary stocks are taking the lead, we can be increasingly confident that traders believe both the economy and the stock market are going to be doing well in the future.
When consumer staples stocks are taking the lead, we can be increasingly confident that traders believe both the economy and the stock market are going to be doing poorly.
You can easily compare the performance of these two sectors by creating a relative strength chart of the Consumer Discretionary Select Sector SPDR Fund (NYSEARCA:XLY) and the Consumer Staples Select Sector SPDR Fund (NYSEARCA:XLP), where XLY is the first exchange-traded fund (ETF) in the pairing and XLP is the second (XLY/XLP).
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 going to be doing well.
Conversely, when the XLY/XLP relative strength chart is moving lower, it tells you that XLY is underperforming XLP and the S&P 500 is likely going to be feeling some bearish pressure.
You can see in the XLY/XLP relative strength chart in Fig. 3 just how bullish sentiment on Wall Street has been since the S&P 500 reached its low on March 23.
What’s encouraging is the chart has not only maintained its longer-term bullish uptrend but also broken out of its latest consolidation range with a bullish surge higher.
Two weeks ago, we looked at the CBOE S&P 500 Volatility Index (VIX), which is also known as the “fear index” because it is such a helpful gauge to measure how worried traders are that the S&P 500 might suddenly drop within the next 30 days.
When the VIX starts moving higher, it is telling you that traders are getting nervous. When the VIX starts moving lower, it is telling you that traders are gaining confidence.
We discussed the chart shown in Fig. 4 and said there were three directions the S&P 500 might move based on where the VIX went:
- If the VIX breaks through the current horizontal support level and starts dropping down toward number 1 on the chart, look for the S&P 500 to climb toward its all-time high of 3,588.11.
- If the VIX continues to bounce up off the current horizontal support level at number 2 on the chart, look for the S&P 500 to consolidate for a while.
- If the VIX breaks above down-trending resistance at number 3 on the chart, look for the S&P 500 to fall back down below 3,300.
We said we thought it was most likely that the VIX would follow option 2.
So, what happened?
As you can see in the daily chart of the VIX in Fig. 5, the index followed option 2.
This tells us that traders are not concerned about an imminent pullback for the S&P 500.
In fact, the VIX is still low enough to potentially test its current support level, which could be extremely bullish for the stock market.
The Bottom Line
Yes, there has been a lot of short-term bearish noise in the stock market the past few weeks as the S&P 500 has pulled back from its all-time high.
However, short-term bearish pullbacks are normal during longer-term bullish uptrends.
We expect 3,200 to hold as support while the S&P 500 explores climbing back up toward its recent highs during October.
On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.