How Our Tools Forecast Last Week’s Selloff

People like to throw around the word “whipsaw” to describe markets making big, quick moves up and down.

After last week’s ridiculous price action, though, we might need a new word for it.

The S&P 500 made a complete roundtrip on the week. On Friday, Aug. 2, it closed at 5,346. The following Monday, it traded at 5,121, or 4.2% lower. Then, by the end of the week, it was back at 5,343… scarcely 3 points lower than it started.

More than plenty of ink has been spilled on what caused such a quick selloff and recovery.

And, frankly, it doesn’t much matter.

If you did nothing, you probably came out fine in the end…

If you acted in the way sudden price plunges tend to inspire, you might be out some money…

And if you’d somehow got a sense of the move beforehand, you may have come out ahead.

Hang on, though… who could have predicted this?

While I would never say “we predicted it,” I’m proud to say that our algorithms broadly forecast the volatility of this event.

And, had you followed our tools or our multiple calls to follow them, you may have sidestepped the volatility altogether… at even higher prices. You might have even profited from the move itself.

It’s due to a strange, little-understood market phenomenon that’s constantly at work, whether you know it or not.

We’ve built tools to help you take advantage of it. And we hired an expert in this phenomenon to help our readers trade profitably by using them.

Here are the tools I’m talking about…

Cycles, Seasonality, and How They Warned of Last Week’s Crash

At TradeSmith, we’re firm believers in the power of data to help you make smarter, more profitable decisions.

If you were a blacksmith, you couldn’t craft a quality sword without the specific hammer that hangs perfectly from your grip, even if you were the most experienced smith around. Similarly, investors can’t trade well if they don’t have access to the financial tools that work for them.

That’s an important nuance. Not every tool is right for every investor. And before you really start to nail the game of building wealth in the markets, you have to find what works for you – and that can take a long time!

Today we’ll focus on two such tools: seasonality and cycles. They work for me, and they might work for you too.

Now, if you follow TradeSmith Daily, you’re likely familiar with our seasonality tools. Editor Michael Salvatore used them to repeatedly warn you over the last month about a soon-to-come spell of volatility in stocks.

Take this example of a TradeSmith seasonality chart of the CBOE Volatility Index (VIX) during election years:

The dark blue line shows you current-year prices, and the green line represents historical prices. During election years, the VIX tends to drift slowly downward from mid-June through August with some big pops in between. That’s broadly what we’ve gotten – save for the fact that the most recent pop higher was far bigger than usual.

With this tool, you can do the same kind of analysis for any asset in our system.

You select either specific years you want to view, all the years we have available, or four different categories of years based on where they fell in the U.S. presidential cycle. For example, this being an election year, I selected “Elections” in the VIX seasonality chart above. Next year, I’d select “Post Elections.”

I always suggest using data from at least three or four election years to get a clear picture of seasonality. That’s if you’re looking at a presidential cycle; if you’re looking more broadly, go for about 10 years of data.

Once you do, it forms a composite of those years’ trading action into one chart.

Viewing my VIX chart, you might note that the volatility of last week came almost right on schedule. This might seem bizarre. And to be clear, I’m not suggesting that this chart or any chart is perfectly predictive.

But history has a funny way of rhyming. Over the last eight election years, volatility tends to pop right around this time – for whatever reason. And this year, it happened again.

Now look at what the green line (historical trend) suggests we’ll see from here: a remarkable surge in volatility lasting through to the end of October – just before we all go to vote in the presidential election.

Over the past eight election years, the VIX has gone higher 87.5% of the time from now through Oct. 28. And counting both up and down years, it’s risen an average of 53.34%. That is significant and suggests to me that there may be much more volatility to come.

But this is just one tool we can use to forecast “unexpected” events in the markets, and trade more cautiously around them…

How the Cycles Chart Helps You Swing Trade

If you’ve never tried swing trading, then essentially you take positions over a matter of days or weeks. Your goal is to outperform the market by taking a larger number of smaller wins – averaging out to a bigger result than buy-and-hold.

This isn’t easy. To do it well, you have to have a finger on the pulse of the whole market and some of the stocks within it. It’s very helpful to know when these stocks historically rise and fall.

That brings me to another observation about markets: assets tend to move in a kind of “rhythm” even aside from seasonality. They ebb and flow… and if you observe enough of these moves, you can average out the time in between them to get a rough idea of a cycle.

Take this chart of the S&P 500 index, for example:

See those orange shaded areas on the top? Those are the “Peak” zones. Based on the data we have for the S&P 500, prices tend to peak ahead of or during those zones.

The blue zones at the bottom are the “Valley” zones. The S&P tends to make short-term bottoms around these times. Again, this is all determined using the S&P 500’s historical trading data.

You can see that the index itself (blue line) peaked just before entering the Peak zone in late July. Then, as it exited the Peak zone, losses accelerated. As it stands today, we’re smack in the middle of a Valley zone, suggesting now’s a good time to buy for a short-term surge (toward the next Peak).

When using these two tools together, it’s easy to see how they give you an edge on swing trading in particular.

Seasonality helps you understand when certain assets – or measures of volatility – are set to rise generally. Following these cycles gives you an idea of the historical trend in an asset.

The Cycles chart, meanwhile, gives you a similar forecast but on a much shorter time frame. With it, you can see when stocks are set to make short-term tops and bottoms.

These two tools together are the keystone of one of our newest and most exciting trading advisories, called Trade Cycles. It’s helmed by William McCanless, and his track record is nothing to sneeze at. William has a fascinating story, too; you can learn about him here, along with a peek at how he deploys our TradeSmith cycles and seasonality tools for swing trades.

All the best,

Keith Kaplan
CEO, TradeSmith