If ever the industry saying, “Sell in May and Walk Away,” were good advice, it was this year, 2015. But when might one get back in? And for investors—especially those with income oriented portfolios or wanting to avoid short term tax consequences—who stayed the course in Q2 and Q3, what evidence do we have that the broader indexes—specifically the S&P 500, Nasdaq, and the Russell 2000—have bottomed?
Even though no one, including me, knows with certainty what the market will do in the future, I would posit that we have five strong technical indicators, suggesting that we’ve seen the 2015 lows and that a “Santa Claus Rally” could occur in Q4. They include: the biggest one day reversal on Friday, 10/2/2015, seen in four years, which produced a bullish “Outside Reversal Bar”; multiple positive divergences indicators, including Momentum and MACD; deeply discounted index prices as evidenced 50 day moving average trading below the 200 day moving average; decreasing sell-side volume, and a Volatility Index Trading below 20 (19.42 at the time of this writing) and below its 50 day moving average.
The Outside Reversal Bar (ORB)
According to Investopedia, an “Outside Reversal” or “Engulfing Bar” is defined as follows:
“A price chart pattern in which a security’s high and low prices for the day exceed those of the previous trading session. The outside reversal pattern is called by candlestick chartists and analysts a ‘bearish engulfing’ pattern if the second bar is a down candlestick, and a “bullish engulfing” pattern if the second bar is an up candlestick.”
“An outside reversal is a price pattern used by technical analysts to help identify potential bearish or bullish price movement in a particular market. It occurs where a price bar falls ‘outside’ of the previous price bar, where its high is greater than the previous bar’s high and where its low is lower than the previous bar’s low. In general, if the outside reversal occurs at a resistance level, it is viewed as a bearish signal; if it occurs at the support level, it is viewed as a bullish signal.”
(Read more: Outside Reversal Definition | Investopedia )
In keeping with this classic definition, it’s of interest that Friday, 10/2/2015, resulted in the biggest Outside Reversal Bars (ORBs) in four years, the equivalent of a 458 swing in the Dow Jones Industrial Average from low to high. That the daily candlestick the following trading day, 10/5/2015, was higher still, suggests that another move higher is potentially in the works.
Positive Divergences on Common Indicators
By definition, a bullish divergence occurs when the prices of a giving index move lower, but that movement is not confirmed by the indicator that tracks it. To the contrary, the indicators move higher as the price action moves lower. (Below, the negative price action is indicated by the red trend line whereas the positive slope of both the Momentum and MACD indicators are shown by the green trendlines.) These divergences, too, often accompany changes in direction. In this case, from negative to positive.
Deeply Discounted Prices: The 50 day versus 200 day Moving Averages
Even though short term swing traders, day-traders, and option traders like to trade in the relative direction of the 50 by 200 day moving averages, long and short, for longer term value oriented investors—buy-side investors with time horizons greater than one year, often interested in long term capital gains treatment versus short term capital gain treatment, i.e., ordinary income rates, in their non-retirement accounts—prices are trading at opportune lows akin to those in 2008, 2010, 2011, and 2014. (See green vertical timelines and green buy arrows below. I offer time lines to compare the buy dates with the same calendar dates a year later and beyond.)
Decreasing Selling Volume
Of all the indicators shared here, volume is perhaps the most illuminating. Imagine, for instance, that you are a hedge fund manager who bet on the adage to “sell in May and walk away,” and “shorted the market.” That is, you borrowed shares of a stock or index from a broker/dealer and sold them with the agreement to buy them back and return them at either a profit or loss. You would have been seeing green, to be sure, for the second half of Q2 and all of Q3, but lately you would have noticed that the volume isn’t accompanying lower prices.
What would you do, then, knowing that you and your firm are on the hook to buy back what you borrowed, so you could return the shares your broker/dealer that lent them to you in the first place? Hopefully, you’d look back at what happened in prior, similar sell-offs and recognize that this down-turn quite possibly has run its course as indicated by decreasing selling volume, and you’d lock in your profits by “covering your short positions.” All the moreso, arguably, knowing that the gains are yours to lose for the year, and the year ends in less than 90 days.
By the same logic, what better time for buyers to get back in the market than when their biggest threat—the large sellers—are buying back those borrowed shares?
The Options Volatility Index (VIX)
True to form, during the mini-crash sell-off in August and September 2015, the Options Volatility Index (VIX) spiked to readings above 30, which is very negative or bearish. By mid-September, however, the VIX dropped to readings in the mid-20s, and, as of today, 10/5/2015, is below both a reading of 20—19.42, to be exact—as well as its 50 day moving average, both suggesting potentially higher prices from here.
Technically speaking, the beginning of Q4 2015 is presenting what I would call a low-risk buying opportunity among the major indexes, the S&P 500, Nasdaq, and the Russell 2000. I say low risk, because in the event that I am wrong, then investors can exit trades with losses consistent with their risk tolerance using stop-losses at predetermined lower prices. But, if correct, the reward could be 1-3 times the amount risked, which, in my experience, makes new buys and/or staying the course on long equity index positions at these prices a worthy consideration.