Is It Different This Time?

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Recession or not, we’re in a volatile stretch… Don’t miss the big picture… Seasonal stock shorts to take from now through November… Checking in on sector health… Why breakout stocks are a godsend right now…

We’re not out of the woods yet…

When market moves are especially dramatic, as they’ve been this past week, it can be easy to fall into a common cognitive trap.

The losses were so severe one day, and the recovery so strong the next, we easily convince ourselves that we’ll be back to “business as usual” in no time at all… and that any concerns of further volatility are to be set aside.

We even have some egg to pull off our face on the economic front. Because the inventor of the Sahm Rule we highlighted on Monday, Claudia Sahm herself, penned an opinion piece in Bloomberg this week hedging against her own theory. Her explanation here:

A rise in the unemployment rate due to weakening demand for workers gains momentum in recessions, which is why the Sahm Rule has worked well historically. But a rise in the unemployment rate due to an increase in the supply of workers is different. […]

There are signs that stronger labor supply, not just weaker labor demand, helped push the Sahm Rule past its 0.50-percentage-point threshold. Unemployed entrants to the labor force (new or returning) accounted for about half of the increase. That’s a notably higher share than in recent recessions, when most of the contribution came from unemployed workers who had been laid off temporarily or permanently. The current Sahm Rule reading is likely overstating the weakening in demand and not at recessionary levels.

You’ll have to pardon us for firing from the hip on that one, dear reader. When an early recession signal with a historically perfect track record flashes, we figure it’s best to play it safe, not sorry. After all, Dr. Sahm’s basic argument here is one that’s gotten investors into a lot of trouble before: “This time, it’s different.”

The reality of recession remains to be seen…

But what we saw this past week is a sign that investors are looking for a reason to sell.

And if we’re going truly conservative, we should consider that we’re now more than 5% down from all-time highs.

Dedicated readers will remember the study conducted by Meb Faber, which we put on your radar during the last correction a few months back, that shows moving to cash past this threshold significantly boosts your long-term volatility adjusted returns.

If you’re at or near retirement, some version of this strategy may be sound to follow. Outside your tax-advantaged accounts, you could consider trimming your riskiest exposure to things like tech and growth and move it into Treasurys.

If we get back within 5% of all-time highs, you can simply reallocate – possibly taking the time to reconsider where best to place your chips.

All in all, you can’t lose sight of the big picture right now…

34 years of market history suggest that we’re not out of the woods just yet.

Below is our long-term seasonality chart of the CBOE Volatility Index (VIX), showing that we could be at the beginning of a volatile stretch lasting for the better part of three months:

Over the last 34 years, the VIX (dark blue line) has risen an average of 21.6% from now through the seasonal peak in mid-October. As you can see, the recent volatility ramped up right on schedule with the seasonal forecast (green line). And notice that volatility has historically risen even more from here – albeit slowly.

We can also look at the election year seasonality chart of the S&P 500 index:

Over the past 18 election cycles, stocks have lost an average of 1.58% from today through the bottom at the end of October. Again, this is lining up with history fairly well. And this chart suggests we may revisit all-time highs once more by the start of September – before things really go sideways.

Of course, there’s no guarantee we’ll stick to the script. But the bottom line is: We’re in the weakest period of market returns historically. We’re set to see more volatility. So, you need to keep playing defense.

One way to do that, as my colleague Lucas Downey showed you earlier this week, is to hold dividend-paying companies. Not only are they a great long-term wealth-builder, they experience lower overall volatility than non dividend-payers.

But if you have a penchant for active strategies, check this out…

Seasonality reveals the stocks set to tank over the next couple months…

And we can find this out by using the same tool we used on the VIX above – seasonality.

Let’s apply the same seasonality tool we used on the VIX to the S&P 500 itself. Specifically, we’ll find the S&P stocks set to drop the most from now, Aug. 9, through the lowest point of election year seasonality on Oct. 25, using the last 20 years of data. That way, we ensure we’re looking at a pretty fixed and relevant set of companies.

As always, we’re filtering out stocks without enough trading data or where one large win skews the data.

Bear in mind, also, that the overwhelming historical trend for stocks is up. It’s not common to find lots of profitable short targets over any span of time.

Regardless, these four tickers popped up:

Symbol	Trades	Avg. Trade	Win Rate
DXCM	18	-4.25%	72.20%
KMI	12	-2.67%	83.30%
K	20	-1.46%	60.00%
HSY	20	-1.12%	65.00%

Over the last 20 years, these four names have on average fallen more than 60% of the time, and those falls have outpaced the S&P 500’s seasonal fall.

Dexcom (DXCM) for example, has fallen more than 72% of the time and with an average loss of nearly 4.25%, over 18 trades.

The highest win rate of the above – though, with the smallest number of trades – is oil & gas pipeline company Kinder Morgan (KMI). It falls an average of 2.67% with a win rate of over 83%.

Important note: unless you know what you’re doing and have a healthy account balance, I don’t recommend shorting stocks. It exposes you to unlimited risk and limited reward.

The much safer and strategically sounder way of trading stocks to the downside is to buy put options. I’d recommend looking at at-the-money strike prices and targeting November expirations. (And if you don’t know what that means, stay tuned. We’re working on a free beginner’s options trading guide that we’ll publish soon.)

It’s worth noting that this trade in Kinder Morgan is an anomaly – our data shows the Energy sector has the best seasonal tailwind over this period, with the Energy Select Sector ETF (XLE) rising 1.5% on average over the last 20 years with a 65% win rate.

While we’re at it, let’s check in on sectors from a Health perspective…

One of my favorite tools in the TradeSmith arsenal is the Sectors view. With it, we can immediately gauge the underlying health of each key market sector:

The Technology (XLK) and Consumer Discretionary (XLY) sectors just entered the Yellow Zone – an area of caution on their health gauge.

These zones are determined by making a composite of the underlying health of each company in each sector. As you can see in the Health Distribution column, both of these sectors have the smallest distribution of Green Zone stocks, and the largest distributions of Yellow and Red Zone stocks.

I love this view because it so quickly and easily shows you where the winning stocks live. Right now, stocks involving the U.S. consumer – like Discretionary, Health Care, and Staples – are in trouble.

Meanwhile Financials, Utilities, Real Estate, and Industrials are in much better shape. These are the areas you want to focus on right now when it comes to mitigating downside and maximizing upside.

They say “there’s always a bull market somewhere”…

And finding it is always the goal – not just when volatility ramps up like this – but to make sure you keep building wealth over time.

For long-term holdings, you definitely want to be looking at the defensive sectors that stand out in the data I just shared.

But there’s also an argument to be made that thinking short-term can help you pile up profits, too.

Luke Lango, a senior analyst at our corporate partner InvestorPlace, uses quant strategies and technical analysis to do just that.

Luke and his team created a tool they call “Prometheus” that is engineered to spot the characteristics of stocks that experience sudden breakouts.

The advantage of spotting these particular breakout signals is that they indicate upside within the next few weeks… not months.

Click here to watch Luke’s free presentation on the Prometheus strategy and why it’s led him to conclude that aiming for many small, fast gains can help ease America’s retirement crisis.

And be sure to tune in to tomorrow’s TradeSmith Daily, where I’ll highlight a number of stocks breaking out amid the broad market volatility.

To your health and wealth,

Michael Salvatore
Editor, TradeSmith