Why February May Be An Ugly Month For Markets: Here Are BofA's "Danger Signals"

With the S&P500 ending January on the back foot, more pain may be in store for markets in February.

This is the observation of BofA's chief technician Stephen Suttmeyer, who provides several danger signals why bulls may want to be particularly cautious ahead of the coming months.

As he notes, the post-Presidential Election S&P 500 rally has done better than the post-Brexit rally, but there are warning signs moving into February just as there were coming off the mid-August post-Brexit S&P 500 peak.

These include complacent VXV/VIX and put/call ratios, a bearish divergence for the US most active advance-decline line, and a Net Tab sell signal. In addition, there is the risk of a weaker
February based on seasonals and the US Presidential Cycle Year 1 pattern going back to 1928. A close below 1.17 on the VXV/VIX as well as a cross for VIM Distribution above VIM Accumulation would increase the risk for following weaker February seasonals.

Of the items listed, we find the seasonal argument most persuasive. While February tends to be a weaker month for the S&P 500 in general and is up only 52.8% of the time with an average return of -0.05% going back to 1928, February is particularly weak in the first year of a presidential cycle: in that case February is up only 41% of the time with an average S&P 500 decline of 2.10%. Even more troubling, when the President is in his first term, February of Year 1 is up only 23% of the time with an average decline of 3.84%.

And then there are the purely "overbought" technicals, chief among which is the VXV/VIX ratio. As Suttmeyer notes, the VXV/VIX is overbought & complacent. The VXV/VIX spiked at oversold levels below 1.0 low on Brexit in late June and ahead of the US Election in early November. Overbought readings can persist and the VXV/VIX has been overbought for the most part since mid November. However, it could go even higher, and would take a decisive move below 1.17, similar to the bearish late August/early September signals, to suggest the risk of a deeper decline in the S&P 500.

Then, there is the 25-day CBOE total put/call ratio which generated a buy signal off the contrarian bullish or fearful levels associated with the US Presidential Election. However, since then this measure of tactical market sentiment moved to overbought in mid December and is on a sell signal off these overbought or complacent levels, which is a risk for February.

Finally, one last tactical concern moving into the weaker seasonal month of February is a bearish divergence on the US Top 15 Most Active A-D line. A bearish divergence occurs when an indicator peaks before the market does. A 12/27 peak for the most active A-D line vs a 1/25 peak for the S&P 500 is a bearish divergence (yellow light) for this important market breadth (and volume) indicator. The most active A-D line measures the breadth of the top 15 US stocks (market cap > 500m) by share volume. When this A-D line falls ahead of the market indices, it suggests that smart money may be selling into strength.

So while a further pullback may be imminent, BofA leaves on a hopeful note: "Many indicators support buying into dips", such as NYSE A/D line, a bullish MACD, Dow Theory still is confirming a buy signal, as well as global breadth which still remains bullish.