A Few Bearish Signals You Need To Watch Right Now…

May begins an ominous period for stock market investors. In fact, there’s even an entire investing strategy built around avoiding stocks from May to October.

According to the “Best Six Months” strategy, that period is the worst time to own stocks. The best time is from November to April.

This strategy didn’t work well over the past six months. The S&P 500 lost 4.6% in the “best” six months. So what should we expect from the “worst” six months?

The worst six months, on average, still deliver a gain about 61% of the time. That’s compared to gains about 80% during the other six months of the year. In the best six months, the average gain is about 7.5% while it’s only about 0.6% in the worst six months.

So, the indicator really tells us we can normally expect small gains from May 1 to October 31.

However, the fact that there was a loss in the “best” six months tells us that the next six months could be a even less rewarding than average. After a decline, there is about a 60% probability of a decline. And the average return over the six months is a loss of 4.5%.

It’s not a definitive “sell” signal, but it’s an important indication that the market is likely to deliver another leg down.

Other Reasons To Be Cautious

Another warning we can expect a new leg down? Amazon’s recent earnings announcement.

As earnings season unfolded, many companies pulled their earnings outlooks, noting that uncertainty is high. Amazon provided some specific insights into uncertainty.

The company’s press release noted that, “Under normal circumstances, in this coming Q2, we’d expect to make some $4 billion or more in operating profit. But these aren’t normal circumstances.” Those funds will instead go toward expenses associated with the current pandemic.

Some of the spending will be unique to Amazon. The company’s CFO noted that Amazon will spend about $1 billion on Covid-19 testing this year. Amazon has designated a team of researchers, engineers, procurement specialists, and program managers to work on building incremental testing capacity. Amazon said the team is building a lab and has already begun a pilot test of front-line employees.

“We’re not sure how far we will get in the relevant timeframe, but we think it’s worth trying, and we stand ready to share anything we learn,” Amazon said in the release about its testing plans.

Other companies will not necessarily research the virus, but some of Amazon’s $4 billion will also fund higher wages for workers, personal protective equipment (PPE), better cleaning protocols at facilities, and “less efficient process paths” that will allow for social distancing.

Those kinds of expenses will affect other companies. Retailers may have to spend on hand sanitizer and PPE for employees while setting up less efficient store layouts that increase spacing between customers.

What The Numbers Say

We are already seeing signs of these changes in the data. As of Friday, more than half the companies in the S&P 500 had reported results for the first quarter. Earnings per share (EPS) for the index are expected to be nearly 14% lower than they were a year ago. But revenue is holding up better-than-expected, down just under 1% compared to the same quarter last year.

One reason for the decline in earnings relative to sales is because of the higher expenses associated with protecting employees. Profit margins for the quarter are dropping to 8.98%, which is significantly below the five-year average of 10.13%.

To me, this indicates there are some important changes in stocks that many investors are probably not considering. Profits will remain under pressure, and risks are higher than they were six months ago. Both of these factors (lower earnings and higher risk premiums) should result in prices resetting at a lower level that’s based on the fundamentals.

What The Technicals Say

Technicals indicate that reset could begin soon. The daily S&P 500 chart (shown below) confirms that momentum is pointing to lower prices, as I explained last week.

I’ve also added a stochastics line to the bottom of this chart to show momentum. This chart shows a bearish divergence and broke below 80, a stochastics level that many analysts watch as a “sell” signal.

The two blue lines in the chart show that the strength of the uptrend declined in the past week, with prices failing to return to the upper line. The blue rectangle highlights the 50% to 61.8% retracement levels. Prices have remained in that range most of the past two weeks.

Closing Thoughts

On their own, none of these indicators is a strong “sell” signal. But it is troubling that so many popular technical tools are near confirmed sell signals. As traders spot these signals, selling could accelerate.

It’s time to watch the market action closely. We are at the point where I expect stocks to struggle. Prices are likely to be lower a month from now. This will be the beginning of the second leg down — and that could induce a renewed sense of panic among investors.

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