The S&P 500 closed the month of May this past week at 2,705.27, recording a monthly gain of 2.16%. May marks the second consecutive monthly increase for the index after consecutive monthly declines in February and March. In my last update (which you can read by clicking here), I wrote in detail about the S&P 500 forming a "2 Inside 3 Setup" though April's close, which was defined as March and April's monthly open-high-low-close (OHLC) bars fitting "inside" February's monthly OHLC bar. I talked about the possibility of May's OHLC monthly bar staying "inside" February's too, which would then record a "3 Inside 4 Setup"...and that's exactly what's transpired, much to my chagrin.
With May's high at 2,742.24, and May's low at 2,594.62, we now have 3 consecutive monthly OHLC bars that fit "inside" February's OHLC bar. The S&P 500 traded at 2,835.96 on February 1st and 2,532.69 on February 9th. The last 77 trading days have been confined between each of these levels. I often state that the S&P 500 will trade beyond the limits of imagination, and I don't think there is anyone who thought on February 10th that the next 77 trading days for the S&P 500 would stay confined between 2,835.96 and 2,532.69.
Since 1970, we have 7 prior samples of a "3 Inside 4 Setup" where the S&P 500 also closed the month above its 12-month simple moving average (12MA). Like the "2 Inside 3 Setup", the S&P 500's return profile over the forward 12 months for all samples following a "3 Inside 4 setup" is mostly horrendous, relatively speaking. The index's forward 12-month return has been red 5 of the 7 samples, and average forward 12-month returns following a "3 Inside 4 Setup" record at -7.64%. 4 of the last 5 samples have experienced a maximum forward 12-month drawdown of at least -20.00% from month-end signal date close (in this case May's close at 2,705.27). Again, it's important to 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. The picture turns decidedly more negative when a calendar month closes above the 12MA, and also records a "3 Inside 4 Setup".
Clearly we all should have sold in May and went away, right? As the great Lee Corso would say, "not so fast, my friend".
First, there's nothing predictive about the "3 Inside 4 Setup" as it's a "crime of small numbers". Second, who's to say the forward 12 months won't behave like the forward 12 months following January 1979's "3 Inside 4 Setup"? That forward 12-month period was very favorable for long-term investors. The point is, a "3 Inside 4 Setup" is not a reason to panic, it's solely a reason to prepare. As I wrote in January, there is no better time to prepare your defense, or risk management plan, than when your offense is on the field. If your defense isn't ready when they need to take the field, you're liable to give up points and lose some or all of your lead. If your defense is ready before they need to take the field, you might be able to able to hang on to your lead - which in this analogy is the equivalent of your unrealized gains that have accumulated over the past 2 years. After a "3 Inside 4 Setup" your defense should be standing on the sidelines, ready to take the field. In other words, you should know exactly what type of future price action will lead you to rebalance your portfolio, or press "sell". Until then, the primary trend remains up, no matter how neutral the secondary trend is. As long as the primary trend remains up, patience tends to pay. The traffic, no matter how infuriating, tends to clear.
We turned the calendar to June on Friday, and the month got off to a strong start with the S&P 500 closing up by 1.08%. With Friday's close at 2,734.62, June is now knocking on the door of clearing its "inside month" by trading above May's high at 2,742.24. Historically speaking, this would be a positive development for June (and really any and all calendar months). Since 1970, when May closed the month above the 12MA, and June's high was greater than May's high, June's closed the month higher 18 of 24 samples (75% win-rate) for median returns of 1.60%. Additionally, the worst June under these parameters is a decline of just -1.76%, and June has recorded as a bearish outside reversal month only 1 of 24 instances. The caveat here is I'm not accounting for when June's high clears May's high, and this June may be unique if this occurs only 2 or 3 days into the trading month. Finally, June's low has never been greater than May's close, and that's the case through one trading day given Friday's "gap and go" session. There are two samples where June's low does equal May's close, given the month of June opening void of any price gaps, but history would suggest there's a good chance we close Friday's gap before the end of the month. Of late, June has had a strong tendency to demonstrate volatility as illustrated by a meaningful drawdown below May's close with 12 of the last 15 June's trading down more than -3% below May's close at some point during the month.
We're also left to question whether a month from now I'll be talking about a "4 Inside 5 Setup". Of the 12 total "3 Inside 4 Setup", when including those that didn't close the month above the 12MA, 6 of them went on to record a "4 Inside 5 Setup". It would appear as a coin flip in that regard. However, June will need to trade up by 4.83% to clear February's high, and that's only occurred 13 times since 1970. Alternatively, June will need to drawdown by -6.38% to trade below February's low, and that's only occurred 3 times since 1970. Interestingly, when referencing the table above, we can see that if June's high is beyond May's high, then June's traded higher by 4.8% or more 9 of 24 instances, an occurrence rate of 37.5%. And when June's high is greater than May's high, June has never experienced a drawdown of -6.83% or worse.
So, what's on my wishlist for this coming Monday or Tuesday? A trade and close above 2,742.24 for the S&P 500. This will help support the idea that the traffic is actually clearing, and we can begin to step on the gas pedal, which will eventually set the stage for a the ultimate rematch - a retest of 2,872. That's where the bulls can either exact their revenge, or the bears can defend their title, and either way I can't wait to see it.