January, where hope and change meets reality.
While none of us really knows what will happen in January, there is a very good chance volatility will appear. The VIX rose from a multiyear low at 11 on the 21st to 14 on Friday. While that is a large percentage move, it may only be a drop in the proverbial bucket. Back in late October, we saw a spike to 23 as the uncertainty before the election reached its peak.
Anything over 20 is considered high an under 13 is considered low. Last January it reached 32 and the prior August it rose to 53. Readings over 30 have only happened 3 times since 2012.
Last January's decline was the worst January in nearly two decades and that is what prompted the move to 32. The Dow dropped more than 2,000 points in just over two weeks. We have that potential again for this January.
Dow - January 2016
One of the easiest trades you will ever make is a call spread on the VIX whenever it hits 30. Those instances are so rare and so brief that it is nearly impossible to lose money. Just set up a conditional trade where a print of 30 on the VIX triggers a sell of the March $30 calls and the purchase of the March $40 calls. Within a week or two, the VIX will be trading back in the low teens and the spread will expire with a profit. We will be using this strategy in the Option Investor newsletter this coming week.
The VIX is calculated from the option premiums on the S&P-500 ($SPX). As fear rises, the premiums rise and that lifts the VIX.
The long time adage in the market is "when the VIX is high it is time to buy, when the VIX is low it is time to go." When the VIX is low, everyone is complacent and they believe the market will just continue higher. That is a danger signal because bad things tend to happen when everyone is complacent.
Conversely, when everyone is most fearful they are more than likely bailing out of stock positions at the market lows.
We had a subscriber several years ago who claimed he only traded 4-6 times a year. Whenever the VIX broke through 20 he bought shares in several of his favorite stocks plus some index call options. When the VIX returned to 13 he sold everything. Then he placed orders to repeat the process the next time the VIX was high. He said it was the simplest system and he never took an overall loss. One or two of his positions may not have performed perfectly because of individual stock issues but overall he made a profit on every cycle and he was only in the market 4-6 times a year.
Most of us do not have that patience. If the market is open, we want to be trading. Unfortunately, that is the wrong method to make consistent gains. We can never be sure when the market or a stock is going up or down and most traders break even at best.
While all the signs point to a potentially bearish January, nobody can guarantee that direction. When all the signs point to a specific conclusion we can position ourselves to profit but we are still at risk of being wrong.
For the last couple weeks, I have refrained from launching a bunch of long positions in the various newsletters because of the bearish signs. I setup several bearish plays and we have been waiting patiently on the sidelines for January to arrive. If the market does as expected, we should do well. If it goes in the opposite direction, we have limited our risk by only having 3-4 bearish positions and we will stop out for a minor loss.
I am excited about our prospects for January but I am not talking about our current positions. I am excited about the potential to buy a significant dip in the market. If you had bought the dip last January and held those positions long term you would have been up significantly for the year. The S&P rose 9.5% for the year BUT it was up 24% from the January lows. I am hoping we get a chance to repeat that potential.
Last week I charted all the major indexes and their potential support points if we saw a January decline. We need to focus on those levels and the market momentum in order to decide when to jump in. I am sure we will be early on some positions and late on others.
Despite the big post election rally the percentage of stocks with a buy signal on the P&F charts has plateaued at 70%. That is the third lower high this year. Only about 50% of the market is bullish despite the rally.
Market commentators last week were talking about the new high on the cumulative advance/decline line. Yes, it did make a new high on the 23rd but it has been straight down ever since. It is not normal for the A/D line to be this high and we can bet it will correct soon. Note the MACD went negative several days before the peak and is moving sharply lower. This is another sign that January could be bearish. All of the A/D charts for the Russell, Dow, Nasdaq, Midcaps, etc look the same. The small caps are the least negative but on the verge of collapse.
A major event in 2016 was the breakout by the Nasdaq through the year 2000 highs. The 5,132 level was broken in July after 15 years thanks to the FANG stocks. However, once through that level the index moved sideways for three months until the election bounce. Now that prior resistance has been broken significantly but those big cap stocks are at risk of being sold in January. Since trading at 1,265 in March 2009 during the financial crisis, the Nasdaq has risen 325%. Now that the investing paradigm has changed, we could see continued rotation out of those big cap tech stocks. Last January was the biggest correction in techs since 2009 but there are still a lot of long-term profits at risk. The weakness in the big cap techs since the election has caused worries that a bigger correction could be ahead. However, I seriously doubt that will happen in the next three months. There is still too much hope in the market.
The S&P broke support at 2,250 and I firmly believe it will retest support in the 2180-2190 range. I think it is a given that we retest that level for a -3.5% decline. However, there is also a good chance we find the next level targeted depending on the news flow before the inauguration.
The good news is that I expect the dip to be bought. There are too many positives in the market for a major correction. Earnings are improving despite the strong dollar. The estimates for 2017 are rising sharply and a change in the corporate tax rate would cause a market explosion. Most of those tax savings would go straight into improved earnings, increased dividends and stock buybacks.
The economic conditions are also improving and that is without decreased regulations and the end of Obamacare. If those things become a reality, the business climate will improve sharply. Institutional investors look well down the road and if they see those possibilities they will be loading up on stocks.
The outlook for hope and change in 2017 should make any January dip a buying opportunity. I would expect bargain hunters in the market the week before the inauguration and assuming there is no terror attack or gigantic civil unrest, the week after the event should be begin a longer rally.
Obviously, I cannot guarantee any market direction but that is my outlook after doing this analysis every day for the last 20+ years.
Enter passively and exit aggressively!
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