For the first half of the year, I’ve been very bullish on the stock market — despite what most of Wall Street had to say. In Q1 and Q2, that worked really well. But to be a short-term options trader, you have to stay nimble, and you have to trade what you see. In August, I saw a pullback incoming.
Last month, I identified bearish technical patterns beginning to take shape — and it changed my directional bias. Specifically, I noted a large bearish engulfing candle in all four of the indices, which quickly led to all four falling below their 50-day moving averages. Now, heading into September, I think the stock market has one more difficult month ahead of it before it can get back on its feet. Here’s what I’m seeing.
Bearish Head & Shoulders Pattern in the SPY and QQQ
A head and shoulders is a commonly known bearish technical pattern in the stock market. Common patterns like these, especially ones that resemble their namesake so well, can often become a self-fulfilling prophecy in the market, with bearish traders exacerbating downside momentum, and bullish traders steering clear in fear of the pattern’s outcome. Heading into September, a usually-difficult month for the stock market (more on that below), the QQQ may be in for a hard road ahead.
To confirm the pattern in full, the QQQ will have to close a day below $355.86 (the bottom of the August 18th candle), and remain below that mark. A close below that level would likely be a preferable point-of-entry for many bears looking to exploit further potential downside. The QQQ isn’t the only major ETF to form a head & shoulders: the SPY is forming one too. And with a little zooming out, we can spot a favorable area for the SPY to fall and retest.
The long red line depicted above forms an uptrend that uses the October 2022 low as a starting point. Depending on how long it takes the SPY to get there, ~$420 could be the level that the SPY retests this uptrend at. This uptrend also coincides with a nearby 200 day moving average, which is currently trading at $413.55. Given September’s common weakness, it wouldn’t be surprising to see the SPY test this line over the next month.
A bounce off that trendline would likely give the “all clear” to bulls looking to get in on the action ahead of the final quarter of the year — a typically favorable quarter for stocks. Until then, be extremely careful buying into any short-term bounces we get — with both ETF’s trading below their moving averages, and showing these two bearish patterns, they’re unquestionably in a weak trading position. After all, we’re about to enter September.
The Stock Market Doesn’t Like September
While it may sound superstitious, the stock market has a propensity to fall during the month of September. It’s the weakest month of the year. Below, two charts sourced from Capital.com identify this.
Indeed, September not only has the worst average monthly performance for the market, but also has the lowest gain frequency as well, dating back to 1972. On its own, this doesn’t necessarily mean anything — after all, the market has still experienced a September gain 45% of the time. But when combined with the confluence of bearish factors we’ve seen above — and when following a massive period of upside like we experienced in the first half of the year, it creates a recipe for a potential stock market pullback.
The Bottom Line: Stocks Will Likely Head Lower in September
I believe due to the confluence of factors shown above that it’s of high likelihood stocks head a bit lower over the next month. I think the SPY is likely to retest the depicted trendline, which may see it trade between $420 and $425 within the next 30 days. With that said, I’m still very bullish on the third quarter of the year. Years that start well often also end well — and this year started very well. Additionally, as you can see in the graphics above, the final three months of the year are typically outperformers, with November and December in particular being two of the strongest three months on average.
Further, many of the bearish catalysts that most of Wall Street predicted didn’t come true. There was no “earnings apocalypse” — in fact, most companies did fairly well. For example, in Q2, 79% of S&P 500 companies reported a positive EPS surprise, and 65% of S&P 500 companies reported a positive revenue surprise, according to FactSet. And there was no “hard landing” — GDP is recovering well, and if the Atlanta Fed’s GDPnow tool is to be believed, we’re in for a massive gain in GDP over the coming quarter. To top it off, inflation has reeled in significantly in comparison to June and July of 2022, which has led many to believe that the Fed is likely done or nearly done with its rate hike cycle.
In short: If you’re a long-term investor, this is all noise. Don’t sell your investments, don’t change anything. The market will recover from any September pullback, and you will almost certainly be fine. If you’re a short-to-medium-term options trader, you’ll want to watch these two ETF’s closely over the next month, and you may consider taking a moderate bearish stance if the risk suits the reward appropriately. However, as always, you’ll want to be careful. Downside action in a bull market is usually riddled with short-covering rallies and bounces — taking too short-term of an expiration could leave you vulnerable to theta decay and volatility. You can mitigate some risk by taking profit often, making a concrete plan before every trade you make, and using advanced tactics like rolling your options in order to scrape profit off of your positions while maintaining your directional bias. Most of all, don’t take on any trade that you’re uncomfortable with — after all, you should only ever risk what you’re willing to part with.
Good luck out there Rebels!