There are a number of reasons to expect a down market next week, and perhaps beyond.
For one, next week is the week after this month’s options expirations, which took place yesterday, and the week after the expirations tends to be down. Why?
I’ll let thestreet.com explain. As they posted yesterday, “A stock market that has been in a steady uptrend tends to rally right into options expirations, and then sells off the following week. The reasons are varied. A lot has to do with the unwinding of large option-related positions that forced the buying of stocks. Another reason is the large number of naked puts sold by hedge funds as the market rose, in order to generate incremental monthly income. There is a vested interest in having those puts expire worthless at the expirations, and thus for the buying of stocks into the expirations so the market doesn’t go down, to assure that the puts do indeed expire worthless. Regardless of the reasons, this pattern tends to manifest itself into the heavy selling of stocks the following week.”
And sure enough, the S&P 500 closed Friday just two points below its October high. So all naked put options sold with strike prices below that level expired worthless yesterday, the cash received by those who sold them being all profit.
Then there is the fact that the last two times the market defied its historical pattern of September usually being a negative month, and September’s strength continuing into mid-October, was last year, and in October, 2007.
Last year, after the market was up in September and its rally continued into mid-October, the market was up on the Monday after the October options expirations, but then topped out, and declined 6% over the next two weeks to the end of October.
And in October 2007, after being up in September and into October, the market topped out on October 9, ending the entire 2003-2007 bull market, and plunging into the recent severe 2007-2009 bear market.
Then there is investor sentiment which is at levels of bullishness and complacency usually associated with the more important market tops.
For instance, in mid-September the poll of its members by the American Association of Individual Investors reached 50.9% bullish, only 24.3% bearish, for a spread of 26.6. It was at 49.0% bullish, 27.7% bearish, for a spread of 21.3, a week ago. It was 47.1% bullish, 26.8% bearish, for a spread of 20.3 this week.
There were only two other times in recent years when bullishness exceeded 50% and the spread was more than 20. The last time was in May, 2008, just prior to the end of the big bear market rally in the spring of 2008. The S&P 500 was 47% lower by November 21. And the time before that was in early October, 2007. The market topped out a week later, and that was the end of the 2003-2007 bull market and the beginning of the 2007-2009 bear market.
More recently, the AAII poll reached only 48.5% bullish, 29.7% bearish, for a spread of 18.8 in April of this year, just before the April top. The S&P 500 was down 17% at its early July low two months later.
Then there is the VIX Index (aka the Fear Index), another method of measuring investor sentiment. It closed Friday at 19, now in its zone of complacency and low fear between 16 and 20, usually seen at the significant rally tops since 2007.
Additionally, the market’s rally since the market’s worst August decline in years, has taken place in spite of worsening economic reports because the Federal Reserve began hinting, and then virtually promising, another round of quantitative easing. The market has surmised that will solve the economic problems, or at least give a boost to asset prices.
The impressive rally since that August low has probably fully factored QE2 into stock prices. That leaves the market not only set up for a classic ‘buy the rumor, sell the news’ scenario, which is liable to get underway with any short-term correction, but also set up for significant disappointment if the size of the Fed’s new round of quantitative easing is not as massive as the market expects, or if criticism grows and becomes believable that QE2 is not the right approach.
So, there are credible reasons to expect the market to pull back some next week, and also for the potential that such a pullback could morph into something more significant.