Finally, Some Clarity

We have all heard the catchy investing phrase “Sell in May and Go Away” and have likely seen the supporting data used to grab our attention. What has always bothered me, not having fully been able to do my own back-testing, was how a few major corrections skewed the data and, if removed, what would the results be. Those major corrections were fat-tailed events and not indicative of a “normal” market. I always wondered if you normalized the data (ie remove those fat tails) what would the data show. Finally, one of my favorite technicians, Tom McClellan did exactly that. 

His bottom line is “Sell in May and Go Away” is not valid BUT being cautious in August and September is as it has been historically a weak period for stocks. I wish I were, but I am not good enough to come up with a snappy rhyming jingle for this “new normal”.

I have pasted part of his analysis below. For those who want to read the entire findings it is available here.

 How Seasonality Has Changed

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We all know about the factor of seasonality, and especially about how it is distilled into the bit of TV news wisdom, “Sell In May and go away”.  That phrase has been around for decades, originally supposedly referring to traders in England who would “Sell in May and go away, and come back on St. Leger’s Day”.  This referred to the custom of aristocrats, merchants, and bankers who would skip town and go to the country during the hot months, returning for the St. Leger’s Stakes, a horse race held in September. Source=Investopedia

It just happens to be a fun rhyme for the U.S. stock market, minus the St. Leger’s Stakes reference, but only during the past couple of decades.  Years ago, seasonality did not work that way, which is what I explore with this week’s chart. 

For years I have employed a file of data I created going back to 1976, a start point chosen so as to have a decent representative sample of what seasonality looks like.  I also elected to omit the enormous bear market year of 1974, and its enormous rebound year of 1975, neither of which makes for a good contribution toward what “normal” looks like. 

Creating an annual seasonal pattern requires several mathematical steps.  One must first chop up the data into 1-year chunks of time.  Next, one must equalize each of the years, as best as is possible, so that the years one is examining are as close to the same as possible.  Back in the 1970s, there were 253 trading days per year, and now it is 252 due to a change in holidays.  And then in years like 2012, when Hurricane Sandy shut down trading for a couple of days, there are days missing.  All of these require adjustments.

I also leave out 1987 entirely, because the height of the peak that year and the depth of the October 1987 crash tend to drown out the voices of the other data.  1987 is not a good example of “normal” market behavior.

Next, each year’s data has to be reset to reflect a percentage change from the start point.  Averaging together a year when the DJIA is above 20,000 with ones when it is below 1,000 makes no mathematical sense, and so we have to adjust for that. 

Once each year’s data is fitted in a Procrustean fashion to our ideal year, we can then then average all of the years together to get an ideal average pattern of what “seasonality” looks like.  But this is only the starting point for doing any meaningful analysis. 

Throwing all possible years together into one average pattern can miss important information, such as a shift in the nature of seasonality.  That is the point behind this week’s chart.  In the 1970s and 1980s, there was not a lot of difference in the months of the year.  The August and September weakness we are all aware of now really was not a relevant factor in that earlier period.

This is fascinating, and a sign that we might not all understand as much as we think we know about what drives price behavior.  Among the theories offered for why summer to autumn weakness is a relevant factor is that financial liquidity gets tied up in the agricultural futures market, as money needs to be available to pay farmers for their harvests each fall, taking it away from the stock market.  But if that factor is not present for a 20-year period, it is probably not a relevant and enduring factor. 

Getting to the “why” is much less important than establishing the “is”.  And the “is” always trumps the “why”, and also the “should”.  The last 20 years’ data show that August and September have become pretty consistently weak months for the U.S. stock market.

Here is a current chart of the DJIA in 2018 versus the pattern of the last 20 years:

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Two for the Bulls

Since I provided two setups for the bears a couple of weeks ago, in the attempt to be fair, balanced and unbiased, here are two setups for the bulls. Neither has provided a confirmed buy signal yet but both are very close and have excellent upside potential.

The first is Adtran, ADTN, which after falling 40 in seven months, has started to form a nice base. Price sits just below near-term resistance, its 200 day moving average and long term trend line. On the positive side, price is above a rising 50 day moving average, has formed a tight flag pattern after a spate of large institutional buyers stepped in and has formed, but not yet broken out of an inverse head and shoulders reversal pattern.

Ideally, I would prefer to see price drift sideways further and create better symmetry (right shoulder is currently shorter than the left) before it moves higher. A confirmed breakout provides a target that is at the underside of the open gap made at the end of last year, a 20% target from here. Of course, all gaps eventually get filled so I would expect price not stop at bottom of the gap and instead easily move though it and instead find resistance back at December’s. If so, the upside target improves to a 38% gain.

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The second opportunity is in Regeneron, REGN. As you can see it is much further along in its recovery from a large selloff than ADTN is. After falling 43% in ~8 months, REGN found a bottom in early May. Since then, price has climbed above its long term trend line, 50day and 200day moving averages. Additionally, the 50 day moving average is now pointing higher and sits just fractionally below its 200 dma. RSI momentum has moved out of the bearish range and now very bullishly aligned. Last week price popped higher on a very large institutional buy, topped right at prior resistance and since then has drifted lower on declining volume. This is a very ideal set up after a large pop as price is consolidating, building energy for an extended move higher. One could look at the current setup as a very large inverse head and shoulders bottom reversal pattern which has a target back at last September’s highs some 30% above yesterday’s close.  Like ADTN, I would like to see the current consolidation drift sideways long enough to improve upon and balance the symmetry of the pattern.

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I feel compelled to say both charts are not quite ready but are setting up for potential large upsides. It could be hours, days, weeks, months or ...? These opportunities may never materialize so think of this as my ideas, your plan. As much as both patterns would benefit from further consolidation, the market does not care what we want so you need to be nimble as you stalk as they could breakout and trigger at any time (or never).

July 2018 Charts on the Move Video

US stock markets are leading the rest of the world higher.  The intermediate term rally in the dollar has either reversed or put the case for over-weighting foreign investments on hold. I think we muddle through the summer/autumn months and then rally into year-end.  Anyone thinking the same? 

July's Charts on the Move video can be viewed at the link below



Anatomy of a Short Sale

When it comes to investing, the terms long and short refer to whether an investment was initiated by buying first or selling first. A long trade is initiated by buying with the expectation to sell at a higher price in the future and realize a profit. A short trade is initiated by selling, before buying, with the intent to buy the stock back at a lower price and realize a profit.  Most everyone understands what being long is but based upon feedback I am getting from some blogs posts, many are not familiar with what a short sale is. So, today’s post I wanted to share a real time example of a short sale I recently placed in my personal account.

The Mechanics

In order to do a short sale, an investor has to borrow the stock or security through their broker from someone who owns it. Once borrowed, the investor sells the stock, retaining the cash proceeds. The short seller hopes that the price will fall over time, providing an opportunity to buy back the stock at a lower price than the original sale price. Any money left over after buying back the stock is profit to the short seller. It’s important to know not all investments are available to short, typically the fewer the number of shares traded on a daily basis the less chance your broker will have a pool available to borrow from.

The Benefits

Shorting, or selling short, allows savvy investors a way to profit regardless of whether the market is moving up or down. The big upside to short selling is that when investments fall they usually fall much faster than they rise so profits can rack up very quickly.

The Risks

Short selling can be profitable when you make the right call, but it carries greater risks than what ordinary stock investors experience. When you buy a stock, the most you can lose is what you pay for it. If the stock goes to zero, you’ll suffer a complete loss, but you’ll never lose more than that. By contrast, if the stock soars higher, there’s no limit to the profits you can enjoy. With a short sale, however, that dynamic is reversed. There’s a ceiling on your potential profit, but there’s no theoretical limit to the losses you can suffer (assuming you hold and never cover – clearly not a good plan).

The Example

The set up for my short entry in BKI was because it formed a requisite 5-touch bearish rising wedge while RSI momentum begun diverging with price, the warning signs of an impending decline. For wedges, a break and hold below the lower support would be an ideal entry for a short sale, which is where placed my order to borrow shares. The rising wedge’s price objective is down at T1 so if this pattern were to get there it would be my plan to cover (buy) some or all of the shares.

Risk Management (if I am wrong) – If price fails to move lower and climbs higher instead, which it has no business doing if the pattern is real, the top of the wedge (point 5) is a great place to put a stop and exit the position. This equates to a ~$1.3/share loss. If instead, price declines as planned and eventually hits the pattern target, the gain is ~$3.9/ share which provides a very compelling 3x reward to risk for this particular opportunity.

Please note, I have laid out my plan BEFORE I enter that includes the strategy to follow for both a positive or negative outcome.  I plan for it to work in my favor but if I am wrong, I don’t want to stay wrong and desire to exit with as small of a loss as possible.

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Fast forward to yesterday and you can see price hit the target and I exited the position in 5 short days. To put it in perspective, it took only 5 days to wipe out what it took the same stock to earn over the prior 40. Stairs up, elevator down and why investors always need a plan. For me, it turned out to be a short term investment, not my plan, but a 7% gain in 5 days works out to be more than a 300% annualized return, something I would take every time if given the chance.  To put it in perspective, 7% is close to the long term returns stocks have realized on an annual basis.

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In Summary

Short selling is fighting the longer primary upward bias in stock prices so it poses a different set of risks that, if not experienced in dealing with, can create big account losses. On the flip side, that upward trajectory has not been in a straight line and those that have been skilled enough to short at the right times and the right investments have been handsomely rewarded allowing those with the knowledge a path to make money regardless of whether the market is falling or rising. With that said, I can’t emphasize enough short selling for the inexperienced is NOT worth the risks. Investing is only done to make money, not gamble and unless you have an investment strategy that has positive expectancy for short sales I would suggest sticking to only going long since you have the strong upward bias as a tailwind increasing your probabilities of success.

Two for the Bears

Topping patterns are set, all that is needed now is confirmation for the bears to be loose.

The first chart of WDC I meant to post 2 weeks ago before it had broken below the neckline of the head and shoulders pattern which occurred last week. If this pattern confirms and follows through, the likely target is down at T1, a 30%+ decline from last week’s close. Before I move on I want to point out if you look to the left-hand side of the chart you can see this is not the first time WDC has formed this pattern. The last time, back in 2015 the stock, broke the neckline, confirmed the pattern and exceeded its target as it fell 68% (peak to trough) before forming a bottom with positive divergence.  Will history repeat? IF so, this looks like an ideal setup for a short.

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The next chart of OAS looks to be where WDC was a couple of weeks ago. It too, has formed a topping pattern but has yet to break below its neckline or confirm the pattern. If it does, the target is down at T1, some 15% below last weeks decline and just above the 200dma. If the market wants to move lower here in the short term, the open gap below T1 is screaming to be filled and where OAS would find major support if T1 did not hold.

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Overall, I am seeing a lot of topping patterns, weakness in stocks that were leaders and bullish patterns that fail. This, combined with troubling action in small caps and at a time when stocks are typically seasonally weak, I am looking to take some risk off the table if the sentiment from earnings announcements continues to disappoint.