In my last Sleuth column, I mentioned that my articles over the past few months on volatility and the VIX Index had struck a chord among Sleuthers. Since that column, I have received a few more e-mails on the subject.

As I said last time, I’m glad the VIX has generated so much interest. I have found it to be a useful tool in analyzing the market’s short-term direction. I’ll touch on this subject again in an upcoming article and address some of e-mails that have been sent in.

But today I decided to take a break from volatility and look at the market from a seasonal perspective. Actually, it’s a subject I’ve written about in some earlier Technical Tuesday columns. However, I haven’t discussed seasonal market patterns since my May 9 article. So with the major averages having recovered nicely in August after suffering through a difficult May-through-July period, I began to wonder what, if any, clues we might be able to draw from this late-summer rebound as we look toward the end of the year.

To search for some answers, once again I took a look back at the performance of the S&P 500 Index from 1970-2005. Since the S&P 500 has now concluded August with a 2.1% gain, I wanted to find out if any inferences for the rest of the year could be drawn from a positive August.

I should point out that, no matter what has transpired in the past, the market is certainly capable of doing anything. However, I do believe you can learn from past market trading patterns because stocks and indexes often repeat prior behavior. That’s one of the reasons that drew me to study technical analysis. Besides, isn’t that why our history teachers used to tell us we studied the subject they taught?

Now, based upon the past 36 years of market history, what does has a positive August in the S&P 500 imply about the likely performance of this widely followed index for the remainder of the year? Before I share with you the data I uncovered, let me first pose — and answer — another question: Why am I singling out August’s results for examination?

I have two reasons. First, as I said earlier, the S&P 500’s profitable August results followed immediately on the heels of a difficult three-month period. Second, August is not only one of the slowest trading months of the year, it’s also traditionally been one of the most challenging for investors as well.

OK, so what did the S&P 500’s performance over the last 36 Augusts suggest about the chances for profitability during the last four months of this year? Here’s what I found…

In the years 1970-2005, the S&P 500 finished the month of August in positive territory on 20 occasions, or 56% of the time. At first blush that may seem a bit surprising, given August’s reputation for being a difficult month. However, in light of the stock market’s inherent upward bias, a 56% positive rate is not exactly an eye-popping percentage. Besides, the cumulative return for the 36 Augusts from 1970-2005 is a mere 0.2%.

Nevertheless, just as in 2006, the S&P 500 Index returned a positive result in 20 of the prior 36 Augusts. So, what happened in those 20 years when the S&P 500 ended August higher than where it began the month? Or to put it another way, was the Index’s ability to forge a positive result in a traditionally difficult month a harbinger of good times for the rest of the year?

Let’s look at the totals. On the 20 occasions from 1970-2005 when the S&P 500 turned in a positive August, the venerable benchmark Index finished the year with additional gains 13 times. That’s a 65% success rate.

Not bad, huh? So, should you rush into the market with all of your remaining investment dollars as soon as you finish reading this column? After all, 65% is pretty favorable odds and much better than August’s 56% overall success rate. To answer that question, permit me to quote well-known college football commentator and former Louisville and Indiana coach Lee Cors “Not so fast, my friend.”

You see, although the S&P 500 followed up a positive August with a profitable September-to-December period 13 times, in four of those years the September-December return did not exceed 0.6%. That’s not a lot of profits for a four-month period, especially when you consider the risk of being in the market. To put it another way, on the 20 occasions when the S&P 500 Index fashioned a profitable August, it was able to tack on additional gains for the rest of the year of 0.7% or greater in only nine years, or just 45% of the time.

If that’s not enough to give you pause, let me throw one more piece of information at you. On the 16 occasions where the S&P 500 lost money in August, it was able to turn a profit over the last four months of the year 12 times, a 75% success rate. Not only that, but the last time the S&P 500 lost money between September and December after finishing August in the red was in 1981. So, if one can read anything into August’s results, it may be as a contrary indicator.

Now, I am not suggesting the historical record shows we’re destined for a rough last four months of 2006, although that could very well happen. What I am suggesting is that one should not assume that the bullish turnaround we’ve just witnessed in the market automatically means that the rest of the year will be positive.

Here’s one final piece of historical data to consider: In those 20 years when the S&P 500 turned in a profitable August, the Index pulled back at least 3% during the succeeding four months on 13 occasions, or 65% of the time. And in 10 of those years, or half the time, the S&P 500 suffered a drop between September and December of at least 6%. So, even if the last four months of 2006 turn out to be bullish, you are likely to get a more opportune time to invest.

If you are looking some more definitive clues on whether, and when, to commit additional cash to the market between now and the end of the year, I suggest you consider using some of the indicators I’ve described in other Technical Tuesday columns. More often than not, those tools will point you in the right direction. Just don’t read too much into August’s results.

Trade well,

Mark Bail
Septmeber 05, 2006

The Meaning of August was originally featured in the Penny Sleuth.

Back in June and early July, I devoted three separate Technical Tuesday columns to the subject of volatility. I did so because I felt that an understanding of volatility could enhance your trading and investment results. 

However, I was spurred to write those columns by the market sell-off that had just commenced. If you recall, when stocks began to slump, many in the financial press were suddenly throwing the word “volatility” around in their daily commentary like they really knew what they were talking about. Since I view the great majority of utterances emanating from the members of the financial fourth estate with a jaundiced eye, my first reaction was to disregard their mutterings as the latest round of mindless blather.

But one thing caused me to rethink my initial reaction. You see, I was aware that the financial pundits were right this time — volatility had increased. And the pundits were right to be talking about it. So, I decided to pen those three columns in the hopes that you could increase your knowledge of volatility and use that knowledge to your advantage when making your trading and investment decisions. 

Well, now that you faithful Sleuth readers are experts on the subject of volatility, I thought it would be a good idea today to look back and see whether that knowledge of volatility has been helpful in interpreting recent market conditions. Also, I thought it would be a good time to apply that knowledge of volatility to see if we can pick up any clues about the present state of affairs in the equities world.

Now, I haven’t heard many of Wall Street’s purveyors of news and commentary wax eloquently on the subject of volatility lately. But that doesn’t mean we shouldn’t be mindful of it. We should. In fact, since the talk about volatility has died down, the VIX has told quite a story.

Why do I say that? If you take a look at a daily chart of the VIX, you will notice that it has traded almost perfectly opposite to the S&P 500 Index over the past three months. And that’s exactly what it’s supposed to do. 

If you recall, I said in my July 11 Sleuth column that “[I]f you look back at the historical price action of the VIX you will see that the index has typically been negatively correlated with the S&P 500. By that I mean a rising VIX Index has generally occurred during times when the S&P 500 is falling and vice versa.”

To be completely accurate, the VIX did not bottom concurrently with the top in the S&P 500 in early May. Actually, the VIX registered its low of 9.88 back on July 20, 2005. It then registered higher lows of 10.15 and 10.53 on December 16, 2005 and March 14, 2006, respectively. However, in retrospect we can see those higher lows were warning signs that a significant top in the S&P 500 lay not too far in the future. 

That’s particularly evident when you consider those two higher lows were made during the same time frame that the VIX put in consecutive lower highs — in October 2005 and February 2006. Thus, as the S&P 500 was traveling upwards toward its May 8, 2006 peak of 1326.70 — with one major pullback between August and October 2005 — the VIX was oscillating in an ever-tighter range. That was another hint that volatility was set to increase and the trading pattern of the venerable S&P 500 was primed to undergo a sea of change.

But what has transpired in both the S&P 500 and the VIX since May is much more interesting — and potentially every bit as valuable. Let’s look at what’s taken place…

The VIX notched its last minor intra-day low of 11.18 on May 5 — just one trading day before the S&P 500 topped out. Then, as the S&P 500 turned south and dropped 6.1% over the next 12 trading days, the VIX soared, reaching an intra-day high of 19.87 on May 24 — the same day the S&P 500 made its initial low. Incidentally, it was that spike in volatility that sparked the comments by the members of the financial chattering classes.

But it didn’t stop there. After a brief respite that saw the VIX briefly poke its nose back below 14 on June 2, this important volatility gauge leaped another 71% over the next week-and-a-half, closing on June 13 at 23.81. That marked the highest level the VIX had reached since April 11, 2003. More importantly, however, that peak in the VIX occurred just one day before the S&P 500 registered an important low.

Over the next few weeks, the VIX alternately put in a new post-May 5 low of 12.74 on June 30 and a subsequent swing to go up to a high of 19.58 on July 18. The June 30 VIX reading was recorded just one trading session prior to the S&P 500 registering an important high on July 3, while the July 18 reading coincided exactly with the next S&P 500 swing low. 

After registering that July 18 high, the VIX has once again moved lower — coinciding with the S&P 500’s late-July/early-August rally. While I find the VIX to be a valuable tool in assessing market trends and trend changes, its accuracy over the past three months in pinpointing turning points has been downright remarkable. 

OK, so where are we now? As I said, the VIX’s recent decline off its July 18 high has corresponded with a rise in the S&P 500. Nevertheless, volatility — as measured by the VIX — remains higher than it was at its 11.18 May 5 low. Unless the VIX can take out that same low on a closing basis, volatility must be considered to be trading in an upward trend — a negative piece of evidence concerning the short-term prospects for that widely followed stock market benchmark.

Just as important, a close by the VIX above its recent high of 19.58 would likely be accompanied by lower stock prices. Not only that, but such an increase in volatility would confirm the current uptrend in the VIX — and greatly increase the chances of the S&P 500 testing its June 14 and July 18 lows.

So, if you want to know if we’re headed for more serious downside market action, or if the coast is clear, keep an eye on the VIX. It’ll keep you on track. Just ask the financial pundits.

Trade well,

Mark Bail
August 08, 2006

Recent Moves in the VIX was originally featured in the Penny Sleuth.

With the large gyrations we’ve been witnessing recently in the major stock indexes, there has been a lot of talk in the financial media about “volatility” becoming more a part of the everyday market.  Although it pains me to say it, the purveyors of business news, gossip, and opinions are right this time.  I guess that just validates the “broken clock” and “blind squirrel” theories.

The stock market has, in fact, been subject to a greater degree of volatility in recent weeks.  But how do we measure that volatility, and what are the financial pundits actually referring to?

It’s a metric constructed by the Chicago Board of Options Exchange (CBOE) known as the Volatility Index — or VIX for short.  Just what is the VIX, and what information can be gleaned from its readings?

Let’s begin by considering what the VIX measures and how it’s constructed.  Once you understand that, you will have a better idea of why you’ve been hearing so much talk about this measurement and the implications you can draw from it.

Here is an excerpt from a report on the VIX found on the CBOE website:

“VIX continues to provide a minute-by-minute snapshot of expected stock market volatility over the next 30 calendar days.  This volatility is still calculated in real-time from stock index option prices and is continuously disseminated throughout each trading day.”

Notice the use of the word “continues” in the first sentence.  That’s because the report I just quoted from was prepared in 2003 by the CBOE to introduce a change in the methodology behind the VIX.  I’ll get to that in a minute.

The VIX was originally conceived in 1993 to provide traders and investors with an up-to-the-minute gauge of market volatility.  The VIX measures the amount of volatility contained — at any moment in time — in option premiums.  In its original form, the VIX was constructed by using a weighted average of the implied volatility of the at-the-money and near-the-money options on the S&P 100 index.

The composition of the VIX was changed in 2003.  At that time, the CBOE created a “new” VIX by making two changes to the original version.  First, options on the S&P 500 index were substituted for those on the S&P 100.  The CBOE decided that the S&P 500 — a widely followed average commonly used by mutual funds as a benchmark to judge their performance results — was more representative of “the market” than the S&P 100.

The second change made by the CBOE was to increase the amount of options used in the calculation of the weighted average.  It was thought that by expanding the number of options used to calculate the weighted average, the VIX in its newer form would provide a more accurate representation of the level of implied volatility currently existing among option premiums in the market.

All options used in the VIX calculation are either in the front month — i.e. the nearest month to expiration — or the second month.  The reason the CBOE limits options to the two nearest months is because it is their goal for the VIX to estimate the implied volatility of what an at-the-money option on the S&P 500 would contain with 30 days left until expiration.

The VIX is quoted in terms of a number between 0 and 100 — and normally trades at the far lower end of that range.  For instance, as of the close of trading on Monday, June 19 the VIX was at 17.83.

That number represents the anticipated percentage movement — both up and down — in the S&P 500 index over the next 30 days.  So, for example a VIX reading of 24 would mean that — based upon the implied volatility in the options on the S&P 500 index in the front and the second months — the index is expected to move within a range of 2% (the 24 VIX reading divided by 12 months) over the next 30 days.

So, why is the VIX important?  For one, it provides you with a reasonable projection of the expected range within which the S&P 500 is likely to trade within the next month.  To use the current environment as an example, the S&P 500 closed on June 19 at 1240.14.  The June 19 closing VIX reading of 17.83 suggests that options traders and investors anticipate that between now and July 19, the S&P 500 is likely to trade roughly within 1.49% range (17.83 divided by 12) of 1240.14 — or between 1221.71 and 1258.57.

Now, that doesn’t mean the S&P 500 will actually trade within that range.  Keep in mind that the VIX changes on a minute-by-minute basis, according to the ongoing changes in the implied volatility in the S&P 500’s nearest two months’ option premiums.

Therefore, the VIX — and hence the projection of the S&P 500’s trading range for the next month — is being constantly revised.  Nevertheless, that projection — as gleaned from the latest VIX reading — is an accurate reflection of the attitude of traders and investors about current market conditions.

And that reflection of traders and investors’ attitudes is the heart of the VIX’s value.  When you can correctly gauge market participants’ attitudes — and then use that information to anticipate likely future price action — you have acquired an additional edge in your efforts to make money in stocks.

In my next Technical Tuesday column, I’ll talk about the meaning of specific VIX readings.  More importantly, I’ll discuss how you can use that knowledge to your advantage.

Trade well,

Mark Bail
June 20, 2006

The VIX was originally featured in the Penny Sleuth.

Ok, the market has rendered its verdict.  The maxim “Sell in May” has turned out to be a viable one. 

The charts tell me that stocks are oversold and due for a bounce.  That’s not wishful thinking on my part.  I’m not a bull or a bear — just a trader and a technician.  From what I see, it appears that the recent avalanche of selling has occurred so quickly that it would not surprise me to see stocks attempt to rally.

Now, that doesn’t mean you should ignore the short-term carnage that has been taking place.  To the contrary, I think the drop in equities over the last week-and-a-half is significant.  But just how significant is it?  And what does it suggest for stocks in the near-term?

To get a sense of what declining prices in May means in historical terms — and what a sell-off in May suggests for the future, I consulted the S&P 500’s historical prices from 1970-2005 to search for some possible answers.

The first thing I wanted to find out was how the current drop in the S&P 500 stacks up against prior May sell-offs.  Before I go further, I should note that the S&P 500 has suffered a 5.6% decline from its intra-day high of 1326.70 on May 8 to yesterday’s low of 1252.98.   

I evaluated each of the previous thirty-six years in the S&P 500 on the basis of the distance the index fell from the high set in the first four months of the year to the subsequent low registered during the month of May.  The only exceptions I made were for the years 1983 and 1999.  Those two years were similar to 2006 in that, in both years, the S&P 500 notched new highs in May before subsequently putting in a low in the latter part of the month.

So, just how common is a 5.6% decline in the S&P 500 from a calendar year high to a May low?  According to the index’s trading history going back to 1970, a setback of that magnitude or greater is very common indeed.  In fact, what is not very common is to see a May low less than 5.6%.

In the thirty-six years I studied, the S&P 500 suffered a pull back to a May low in excess of 5.6% thirty-one times. That’s better than six out of every seven years!  Moreover, the average decline in the S&P 500 from 1970-2005 from a calendar year high to a subsequent May low was 8.6%.  In other words, the sell-off we have seen so far is rather mild by the S&P 500’s historical standards. 

However, the key question to try to answer at this point is, what can we expect next?  Now, I’m not suggesting that we’ve seen the lows for May.  My purpose in writing this article is to see if we can get a heads up on what the future might hold by taking a look into the past.  Let me just say that — whether we’ve seen the lows for May or not — the present trend is bearish.  And although I expect the market to attempt to rally from the recent sell-off, I don’t believe we’ve seen the lows for 2006. 

Nevertheless, to see if my expectation of a further decline has a basis in recent market history, I did some additional searching through the S&P 500’s historical data.  What I found only confirmed my suspicions — and what I think the current chart patterns are telling us.  Let me share some numbers with you.

Between 1970 and 2005, the S&P 500 violated its May bottom in a subsequent month on twenty-three occasions — or 63.9% of the time.  Thus, the chances are favorable that — whether we have already seen May’s lows or not — even lower prices await us sometime between now and the end of the year.

That’s not all.  If the S&P 500 has already marked its low for May, the odds of seeing a lower low sometime between June and December becomes infinitely greater. 

On eleven of the thirteen occasions where the S&P 500’s May low marked the low for the remainder of the calendar year (including 2003 and 2005), — the index had already suffered through a decline greater than the 5.6% we’ve witnessed so far.  Only in 1993 and 1995 did the index post a modest decline into its May low and then turn up for the rest of the year.

What this means is that — despite the seeming severity of the recent drop in stock prices — the worst is yet to come.  Whether or not we have seen May’s lows, according to the S&P 500’s historical trading pattern, odds favor still lower lows for the index.

What does that mean for you?  If you are a trader and hold several positions, you may want consider lightening up.  Given the swift, sharp nature of the recent plunge, we have quickly reached an oversold condition in the market.  You might want to consider using a recovery rally as an opportunity to close out — or cut back — on some of your long positions.

If you are an investor with a long-term timeframe, you might not be as concerned with the latest setback in stock prices.  After all, according to trading patterns going back to the 1970s, the decline we have witnessed to date has been a rather modest one.  So, the recent turbulence may not concern you a great deal.

Nonetheless, based on the historical data I have cited, you might want to use a near-term rally to consider lightening up a little on your holdings — or making some minor adjustments to your portfolio.  If the action of the last few decades is any guide to what lies ahead, we’re likely to see lower prices some time later this year.  And if that turns out to be the case, odds are good that you’ll be able to repurchase some of your favorite stocks at even lower prices.

History doesn’t always repeat itself in the same way.  But patterns do have a tendency to recur.  That’s one of the reasons technical analysis can be useful to your trading or investing efforts.

Trade well,

Mark Bail
May 23, 2006

What Can We Expect Next? was originally featured in the Penny Sleuth.

As you may recall, earlier this year I opined that equities would have a rough time in 2006.  With almost four months of this year in the books, that prediction looks to be among my least notable achievements.  My, the market can sure be humbling!

Now, as I mentioned at the time, seer saying is not my strong suit.  I leave the predicting business to some of my Agora Financial colleagues, those whose longer-term outlooks better fit the “big picture” approach you need to have in order to successfully forecast trends and long-term market shifts. 

My specialty, on the other hand, is in discerning — and exploiting — short-term price movements.  That’s what I’ve done in my trading career and that’s what we focus on in MST Trader.  I concentrate on what the market is doing right now and seek to find the most profitable opportunities within that short-term environment.

So, with nearly four months of the year behind us, I wanted to get a bead on what was likely to transpire throughout the rest of 2006.  In other words, does this positive start to the year portend a solid year overall for equities?  Or do bullish beginnings frequently melt away in the heat of the summer and turn to fool’s gold by year’s end?

In order to locate some clues as to what the bullish start to 2006 portends for the rest of the year, I checked the returns in the S&P 500 for every year going back to 1970.  Permit me to share with you some of the results I found.

In the 36-year period from 1970-2005, the S&P 500 finished in the plus column on 27 occasions, or 75% of the time.  Now, that’s really no surprise.  Despite some tough times for equities in the 1970s and the rocky 2000-2002 period, much of the past 36 years has been bullish.

But nearly four months have already gone by this year.  And through Monday, April 24, the S&P 500 sits 4.8% higher than where it ended 2005.  So, while it would be great to trade the past, it’s our ability to get in step with the present and future market trends that will determine our near-term success.

So, how has the S&P 500 performed over the last eight calendar months of the year?  I went back over the numbers — factoring out the January through April results for each year — and studied the index’s returns from May 1 through the end of December.  And while the number of profitable May through December periods were not as great as they were for the full calendar year, the index did manage to close out the year at a higher level than where it sat at the end of April on 25 occasions, or 69% of the time.

That’s fine.  But what I really wanted to find out was if the first four calendar months tipped us off to what we should expect for the rest of the year?  Or is there no relation between the immediate past and the immediate future?  In other words, is the past prologue?

What I found was interesting.  It turns out that, in the 36-year period from 1970-2005, the S&P 500 was able to turn a profit during the January through April timeframe on 20 occasions, or 56% of the time. 

Now, on the 20 occasions that the S&P 500 finished the first four months of the year in positive territory — like it appears it is going to in 2006 — the gains captured exceeded the profits that were later obtained, on a percentage basis, throughout the rest of the year.  Conversely, during those 16 years where the S&P 500 ended April at a lower level than it had started the year, the index would, on average, exceed those desultory initial four months results during the remainder of the calendar year.

So, does that mean that a bullish start leads to bearish results and vice versa?  And should I hold out hope that my earlier bearish equities forecast is likely to bear fruit?

No, no, a thousand times no!  You see, when I delved further into S&P 500’s historical results I found something quite different.  What I discovered was that the past, in fact, is prologue. 

I separated out the 20 profitable January to April periods and analyzed them separately from the 16 unprofitable ones.  I discovered that on all 20 occasions that the S&P 500 turned a profit during the first four calendar months, it ended the year in the black.  Conversely, when the S&P 500 was behind the eight ball at the end of April, it was only able to pull itself into positive territory by the end of December seven times.

Now, you may be wondering what’s so impressive about the S&P 500 turning a profit when it already has a positive head star after one-third of the year.  I know that very question crossed my mind.  So, I pushed my inquiry a little further.  I wanted to find out whether the S&P 500 was more or less likely to tack on additional gains if it was ahead after the first four months of the year.  In other words, is the past prologue?

Now, remember that in 25 of the 36 years between 1970 and 2005, the S&P 500 turned a profit between the months of May and December.  Well, in 17 of those 25 profitable May to December periods, or 68% of the time, the S&P 500 posted a profit after having already climbed higher in the prior four months. 

To understand the significance of this statistic, keep in mind that the S&P 500 was only profitable in 20 out of the 36 January to April time periods during the years 1970-2005.  What that means is that in 17 out of those 20 years — or 85% of the time that the S&P 500 started the year in bullish fashion — it managed to close out the year at an even higher level.  So, based upon the historical pattern of the last 36 years, it is highly likely that the S&P 500 will conclude 2006 at a higher level than it is currently trading at now.  So, yes indeed, the past does appear to be prologue.

Does that mean you should follow a buy and hold strategy for the rest of the year?  Not necessarily.  But it does suggest that — despite rising interest rates, record oil prices, soaring commodities, and a host of other daunting foreign and domestic challenges sure to continue to worry investors — the odds do not favor the bears suddenly seizing control of the market and driving it off a cliff.

I guess I’ll need to file that bearish prediction of mine and save it for another year.  Meanwhile, in my next column, I’ll discuss a couple of other patterns I uncovered when mining the S&P 500’s historical data.   

Trade well,
Mark Bail

Is the Past Prologue? was originally featured in the Penny Sleuth.