Stock prices have had an impressive run, especially considering the risks facing the global economy and the growing uncertainties fueled by the looming fiscal cliff and the upcoming election. During the recent market advance, investors have become increasingly complacent, evidenced by declining levels of both implied and historical volatility. The market rally will be tested in September, which historically has been the worst month of the year for stocks.
Stocks: The September Effect
The top panel in Figure 1 below is a weekly candlestick chart of the E-mini S&P 500 continuous futures contract through Friday August 24, 2012. The second panel is one of my custom seasonal indicators, which calculates the average compound annual return earned over a 30-day holding period for all beginning dates throughout the calendar year. The calculation assigns a higher weight to more recent periods. Finally, the bottom panel in Figure 1 is a custom SWAMI seasonal correlation chart, which evaluates how accurately the recent price behavior matches the historical pattern.
As you can see by the indicator value in the second panel (inside the red box), the historical compound annual 30-day return for the S&P 500 index is -23.68%, which is the lowest value of the year. The recent price behavior has not matched the historical seasonal pattern (see third panel), which may mitigate the risk of a pullback in September, but there is still cause for concern. The seasonal pattern does not turn bullish again until early October (green box in second panel below).
Historical Volatility: The September Effect
Reduced volatility typically goes hand-in-hand with a market rally and the recent uptrend is no exception. The blue line in Figure 2 below represents the annualized historical volatility for the E-mini S&P 500 (ES) continuous futures contract. The purple and red lines are the weekly average annualized historical volatilities calculated over two different long-term periods.
As you can see from the chart in Figure 2, the current level of historical volatility of 12.54% is far below the seasonal historical volatilities of 17.40% and 19.83% normally experienced during the last week in August (see green box on the right side of the chart).
The box on the left side of the chart depicts the historical volatility of the ES contract from August to December last year. Volatility normally increases in August and September, peaking in late September or early October. Last year the historical volatility of the ES contract spiked to over 42% (blue line) in late August in an exaggerated example of the normal seasonal volatility pattern for the ES contract.
The seasonal increase in volatility in September is consistent with the seasonal decline in equity prices. Volatility and equity prices are negatively correlated.
Given the recent run-up in prices and sharp decline in volatility, the market is overdue for a correction. Negative seasonal factors, overhead resistance, and a whole smorgasbord of external risks may finally be sufficient to break the back of the uptrend
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