Fair Warning: Markets Could Get Ugly!

Let's start out today's oftentimes meandering morning market missive with a question.

Is there anyone out there who expects the stock market to decline in the month of December? Well, other than those die hard perma-bears who have a tendency to expect the stock market to decline every month, that is? Didn't think so.

So, the first point this morning is that with the S&P 500 (NYSE: SPY) still up more than 25 percent on the year and history suggesting that the Santa Claus rally will bring good tidings to investors, most folks may be expecting that an advance for the market indices in December is a slam dunk. After all, everybody knows that year-end "window dressing" tends to boost prices at the end of a year in bull markets, right?

Something Everyone Knows...

However, as Ned Davis is famous for saying, "Something everyone knows in the stock market isn't worth knowing." In other words, if everybody knows about a market tendency, it isn't long before it stops working.

As such, perhaps it isn't a good idea to get too comfortable with the expectation that stocks will soon pull out of their now five-day old funk and resume marching ever higher into the New Year.

See also: Taper Tantrums Continue to Dominate Market Action

Yet at the same time, stocks DO tend to rally in December. As well as into January, February, and March. As anyone who knows their market history can attest, the November through April period has historically been the best time of year to be invested in stocks. And for anyone not familiar with this seasonal pattern; look it up, you will likely be amazed.

In addition, sometimes things in this game become "self-fulfilling." This means that although everyone can't be right all the time, if enough folks are thinking along the same lines, group-think can take over. (This is why most bull markets last longer than the bears can ever imagine.) So, just because "everyone" expects the market to advance in December, doesn't mean it won't!

Just Don't Get Too Comfy

Okay, time to move forward and talk about something that "everyone" doesn't know about. Although history does indeed support the idea that stocks will likely advance in the first quarter of next year, most investors probably are not familiar with what tends to happen in the second quarters of the second year of a President's term (aka the mid-term year).

Cutting to the chase - it isn't pretty! You see, bear markets have a nasty habit of showing up during the second year of the four-year Presidential cycle. And for some reason, a great many market peaks tend to occur in the second quarter of those mid-term years.

How Bad Will It Be?

Since 1934, there have been twenty such mid-term years. If one measures the decline from the prior high to the low of the mid-term year, the average decline measures -21.4 percent (and the median decline is -21 percent). Ouch!

See also: What Do The Cycles Say About December?

For example, the last mid-term year was 2010. The high was seen in April and the low was in July. If you will recall, Europe caused some difficulties for the market that year (and the next, and the next). The total decline seen was -16 percent. In 2006, the decline was -7.7 percent. In 2002, it was -33.8 percent. And on it goes.

Sometimes It's Bad... Very Bad

Some years, the pullback is modest - somewhere in the two to five percent range. And then in other years, a full-fledged bear market takes place. In fact, exactly one-half of the mid-term years have produced declines of 20 percent or more, which is the base-level definition of a bear market.

And here comes the really scary part. The average decline experienced during those bear market years has been nearly 30 percent (29.79 percent to be exact).

So, while anything can happen in this game, investors (especially those who are uber-bullish at this time) may want to be on the lookout for any type of negative catalyst (Fed tapering perhaps?) in the coming months. Because, if something out of the blue crops up, history shows things could get ugly in a hurry.

Click Here For More "Daily State of the Markets" Commentary

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of the Taper (aka Fed Policy)
      2. The Outlook for Economic Growth
      3. The State of the Bull Market

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend:
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend:
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend:
(Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

• Near-Term Support Zone(s) for S&P 500: 1780
• Near-Term Resistance Zone(s): 1800-1813

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

• Trend and Breadth Confirmation Indicator:
• Price Thrust Indicator:
• Volume Thrust Indicator:
• Breadth Thrust Indicator:
• Bull/Bear Volume Relationship:
• Technical Health of 100 Industry Groups:

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

• Overbought/Oversold Condition: The S&P 500 is from a short-term perspective and remains from an intermediate-term point of view.
• Market Sentiment: Our primary sentiment model remains.

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading:

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Wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
StateoftheMarkets.com

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

Positions in stocks mentioned: none