The S&P 500 closed the month of April at 2,648.05, recording a price-only monthly gain of 0.27%. In my last post, which you can read by clicking here, I shared why I believed that April's low would be lower than March's low, and why April's close would be above March's close. While both did come to fruition in April, it did so by the slimmest of margins with April ending the month on a sour note. Every rally since February has been sold, and April was no different. The S&P 500 traded down to 2,553.80 on April 2nd, only to then springboard to 2,717.49 twelve trading sessions later. But the bulls continue to turn the ball over at and around widely followed levels of resistance, and when they had 1st and goal at the 1 they fumbled the ball away, marking a meaningful reversal right next to the 20-week simple moving average. While I had hoped that April's price action would solidify the bottom of this correction is in, and provide further behavioral evidence that price is onward and upward from here, that certainly did not come to fruition. The actions and behaviors of millions of market participants has a keen way of maximizing uncertainty, and the S&P 500's forecast at the moment is mostly uncertain.
We now have two monthly open-high-low-close (OHLC) bars that fit "inside" the bar from three months prior. In other words, the highs from March and April are below February's high, and the lows from March and April are above February's low. Let's call this the "2 inside 3 setup". If the primary takeaway from a singular "inside month" is behavioral uncertainty via price compression within the prior month's range, then my primary takeaway from the "2 inside 3 setup" is leveraged uncertainty. The S&P 500 is like a coiled spring at the moment, oscillating wildly between clear levels of support and resistance, building the energy to explode in a particular direction when she's ready. That part is certain; it's the directional part that's uncertain, but the historical tendency following the "2 inside 3 setup" is not exactly encouraging to us bulls.
Since 1970, we have 11 prior samples of the "2 inside 3 setup" where the S&P 500 also closed the month above its 12-month simple moving average (12MA). Generally speaking, filtering any study by calendar months that only finish above the 12MA will fit the study toward mostly bullish outcomes. However, that doesn't occur in this scenario. The S&P 500's return profile over the forward 12 months for all samples following a "2 Inside 3 setup" is mostly horrendous, relatively speaking, and especially of late. The index's forward 1-month return has been red 5 of the last 6 samples, for average returns of -2.50%, and the index's forward 12-month returns have been lower 4 of the last 6 instances, for average returns of -5.45%. Each of the last 6 samples have experienced a maximum forward 12-month drawdown of at least -12.95% from month-end signal date close (in this case April's close), with the average maximum forward 12-month drawdown over the last 6 samples being -17.00%. Keep in mind that since 1970, the S&P 500's return profile for all calendar months that finished above the 12MA is generally positive, with average forward 1- and 12-month returns of 0.90% and 9.50% respectively. This study ran completely opposite to what my expectation was prior to running the study.
Given the S&P 500's natural tendency to head north over time, I always pay attention to studies that run completely counter to both my expectation and the index's natural tendency. While 11 prior samples can't possibly demonstrate predictive qualities, it doesn't mean it's useless information. One can argue that investing for success over the long term is not always about having a system with predictive qualities, but also about optimizing entries and exits and adhering to your long-term investment plan with the discipline of 1,000 Navy SEALs. This study simply leads me to keep an open mind to bearish possibilities over the remainder of 2018, something that runs counter to my optimism that was established following the bullish behavior of market participants in December of 2017 and January of 2018. While the primary trend remains up or "bullish", and I believe we'll set new all-time highs in the summer, studies like this help me keep the risks of complacency and overconfidence at bay.
As we head into May, I'm left to wonder if 3 will ultimately fit "inside" 4 - that is, will May's high and low also stay within February's high and low? It certainly seems likely, as the S&P 500 will need to trade higher by 7.10% in May to eclipse February's high at 2,835.96. Since 1970, May's traded above April's close by 7.10% or more just twice (1990 and 1975). That's an occurrence rate of just 4.16%. Alternatively, it will take a decline of -4.39% for May to trade below February's low. Since 1970, May's monthly drawdown has been -4.39% or worse 11 times, with the most recent samples being 2012 and 2010. This marks an occurrence rate of 23%. If we do actually remain confined between February's high and low, it will draw reference to the two most recent samples; July of 2000 - as the market was trading sideways, transitioning from a primary uptrend to downtrend - and April of 1990 - as the market was trading sideways, transitioning from a primary uptrend to downtrend. See the common theme here? Put simply, the S&P 500's inability to find higher highs following February is becoming an ominous sign about the future sustainability of our primary uptrend.
So May is here, and it has actually turned into one of the better performing calendar months over the last few decades. While May has closed higher 29 of 48 times (60%) since 1970, it's closed 22 of the last 30 (73%) higher, and 5 in a row to the upside. Over the last 30 years, May's median price only returns are 1.22%. We also enter May with the S&P 500 closing April above its 12MA. This has occurred 23 times since 1970, and two observations I noted were that if April closed above the 12MA, May has then never closed below the 12MA - i.e., 23 of 23 samples also saw May close the month above the 12MA (the 12MA is presently ~2,603). Additionally, if April closed above the 12MA, May's then never been an "inside month" - that is 23 of 23 samples either traded above April's high, or below April's low, or both (there's 3 outside months in the data set). Therefore, history would suggest it's highly likely we trade above 2,717.49, or below 2,553.80, in May. The former opens the door to retest March's closing high at 2,786.57, and the latter opens up a test of February's low of 2,532.69. Wouldn't that be ironic given the "sell In May and go away" narrative, especially if the retest of 2,532.69 is successful. Pure conjecture here, but hindsight could mark a successful retest of 2,532.69 as one of the best buying opportunities of the year...in May. Go figure.
Finally, the S&P 500 has been on sale for three months now, with a sale being defined as times periods when a clear uptrend experiences a pullback or correction to its 200-day simple moving average (200DMA). If the strength in December of 2017 and January of 2018 was a derivative of market participants believing in the story of higher prices throughout 2018, then one would expect market participants demonstrate eager buying interest into the S&P 500's sale. If equities are analogous to a quality product that everyone believes in, then the natural expectation is for discounted pricing to bring eager buying interest to the marketplace, thus leading the inventory to sell out fast. This is exactly what happened during each of our prior sales in November of 2016 and June of 2016. Participants bought the sale by the dozens, driving prices to new 52-week highs in short order. However, the behavior of market participants in response to our current sale is clearly different. While many participants are buying the inventory, as evidenced by the 200DMA holding as of now, others are are clearly returning the product only weeks later, as if the product is no longer something they believe in over the intermediate- and longer-term - even in spite of terrific earnings and a reasonably sound economic backdrop. It's a bit worrisome at the moment, but it's by no means a definitive sign the bull market is over. As they say, bull markets often "climb a wall of worry". I believe the most likely scenario over the months ahead is new all-time highs, but the market is finding a way to maximize uncertainty so that only the most skilled traders, and disciplined long-term investors, capture the majority or all of the potential move to the north. Weak hands don't get paid.