There is no emotion that can drive the market faster than uncertainty and fear, especially during the month of October.
Already known for its volatility and selloffs, the month of October is often the last test for investors before stocks hit one of their strongest two months of seasonality: November and December.
This year looks to be no different.
Tensions in the Middle East are boiling over.
Investors are growing more concerned over the elections, just one month away.
To add to it, we’re getting ready to head into the earnings season and we’ve got a very high probability of an "October Surprise” over the next three weeks.
Breaking Down the Signs
The CBOE Volatility Index (The VIX) moving higher suggests that options traders are preparing for a decline, but that’s not true of the average investor.
According to the CNN Fear and Greed Index, investors are “greedy”.
Greed is also associated with complacency, and there’s nothing more dangerous than a complacent market.
Any negative catalyst or trigger will send investors from their complacent state into a state of fear, which is always accompanied by fear-based selling. These are the type of selling conditions that get out of hand very quickly.
It’s usually a good thing when earnings season starts, but that hasn’t been the case over the last few quarters.
Put simply, investors expectations are just too high, and that’s not great for stocks.
High expectations mean that companies need to post extremely good earnings results to continue to rally.
Last quarter, the S&P 500 dropped nearly 10% starting just two days after the beginning of the earnings season.
The quarter before (April), the same index dropped 5% as earnings season started.
January’s earnings season saw stocks rally, but last October’s earnings season kicked off a 5% decline.
Four quarters don’t make it a sure thing by any measure, but earnings season has turned into something that
I know, we just finished September, which has the worst track record for stock market seasonality, but October has its baggage as well.
October is known as the “cardiac comeback” month, at least that’s what we call it. The reason is simple, the beginning of the month is often scary with fast and aggressive selloffs, but those turn to great buying opportunities for what’s to come.
Looking at the average monthly “downside” (or the average amount the S&P 500 falls over the last 20 years) finds that October posts the lowest lows. In other words, the S&P 500 has a habit of selling off more than any other month of the year.
Historically, those October bottoms lead to spectacular seasonality for November and December, which are two of the best months of the year to own stocks.
This could be its own article, but I’ll get right to the bottom line.
Historically, October is a decent month for the market. Since 2000, the month of October averages gains of 1.4%, pretty good, but there’s a catch.
Looking at election years only, the average return for the month of October drops to -3.6%.
This goes back to one of the basics of the market, investors hate uncertainty.
Let’s face it, elections years have been getting more and more uncertain over the last two decades.
This year, well I think we already know about the level of uncertainty we’re heading towards.
For this and this alone, we should expect investors to start selling at the first sign of anything going wrong.
Earnings, earnings warnings, Geopolitical, elections, the Fed not cutting by another 0.50%, ANYTHING.
What Investors Should Watch
I’ve already mentioned it, the CBOE Volatility Index is the easiest indicator to watch to gauge when investors start heading for the doors.
The “VIX” is already moving above the 20 level. That indicates that the options market is starting to get nervous about stocks.
We will begin to see an acceleration in selling and prices start to drop faster as the VIX crosses above 25. That’s your “trigger” or indicator that the market is setting up for fear-based selling to take stocks lower.
How Low Could the Market Go?
The current chart suggests that the S&P 500 could quickly drop 5-8%.
The broad index S&P 500 traded to $5,200 in August, which is where the S&P 500’s 200-day moving average sits ready to provide technical support.
A break below that price will turn things uglier with a target of $5,000 for the S&P 500, a 12% drop from current prices.
How Do You Trade This Situation?
The month of October is well known as a great time to buy into the market to prepare for what is normally a strong November and December.
The average “buy and hold” investors will want to just be aware that the volatility and selling is appropriate for the market during October and be prepared to buy stocks on the dip.
It’s the hardest thing to do but remember that its best to buy “when there’s blood in the street”, not when everyone else is buying. A VIX reading above 40 will start to signal that investors are acting on fear, not greed.
Also, check the CNN Fear & Greed Index for confirmation of fear driving the market to signal an “all clear” signal to begin preparing for the market’s recovery.
Options traders would consider put options on the SPY or QQQ as a short-term hedge.
Many investors can get a little too aggressive by trading the weekly or Zero Day to Expiration options. I always remind investors that a hedge is not something that you pinpoint to a day or even a week.
For that reason, longer dated options provide an effective hedge in these situations.