Liquid Momentum Column (Originally published on June 29, 2012)

The “Summer Doldrums” is commonly referred to on Wall Street as the timeframe between Memorial Day (May) and Labor Day (September) of each year. It has historically developed enough of a reputation for being a period of corrective activity for the majority of stocks, so much so, that investors will want to consider either raising cash or taking on a more risk-averse approach during this time.

Don’t believe it? Let’s look at some numbers over the last two decades.

Starting with 1991 to present day, the S&P 500 has experienced an average decline of approximately -6% at some point from its early May highs during the following four months into September, on 16 out of 21 occasions (or about 76% of the time).

Currently the S&P has fallen as much as -9.5% since its early May highs and there's still at least 2 more months to go.

There are a few theories on why the markets succumb to this “seasonal sell-off," but the one that is most commonly accepted simply has to do with the “weather.”

As humans, we are confined indoors during most of winter. Call it “cabin fever,” but once the warm, sunny days of spring and summer roll around, many of us prefer to spend as much time as possible enjoying the fresh air outdoors. Children have completed their academic year and the opportunities for experiencing life, traveling to a beach, or taking a vacation with family and friends, is simply part of our nature and culture.

In turn, that “absence” (particularly from larger portfolio managers) can translate into less participation (or liquidity), therefore creating more volatile and sporadic movements in stock prices. The reactions to global headlines, earnings, analyst comments, etc., become more exaggerated than normal. This theory has also been popularized by the adage of “Sell in May and Go Away.”

The chart below highlights the S&P for the last 2-1/2 years, identifying a “textbook” example of “summer corrections.”

Summer Ranges Define Cyclical Trends

One observation I have made over the years for determining the broader “cyclical phase” of the market has been to compare the current “summer range” to the prior year’s “summer range.”

On the 20-year monthly chart of the S&P below, we can see as long as the market does not “undercut” the prior year’s summer range lows, then a cyclical uptrend remains intact. However, when the market does drop below prior summer range lows, the potential for a more aggressive bear phase can develop.

As a general conclusion, the key thing is to recognize first, the potential danger that could develop if the prior summer range lows are broken; and second, acknowledging the potential ensuing rally above the current summer range that keeps the upward bias alive.

As of this writing, as long as the S&P remains above the 2011 summer range lows of about 1100, I’m inclined to say the cyclical uptrend off the 2009 lows remains intact. If that were to be broken, or if the latter half of 2012 undercuts this year’s summer range lows once established, I would consider the chances of a deeper bear phase to be in full effect.

Identifying the Next Potential Leaders

Bottom line is from an investor’s viewpoint, it often pays to err on the side of a more cautious approach during these summer months.

However, while your money is not participating 100% in the market, that does not mean you should be ignoring the action completely.

In fact, this is exactly the time where it will often pay off to be on the search for the next potential leaders to pace a rally higher.

Briefing.com’s proprietary Liquid Momentum Focus List highlights 50 of the most liquid, highest relative strength stocks in the market on a weekly basis. Not only are they ideal candidates for both Day and Swing trading, but they also qualify for more intermediate-term position trades.

Due to the inherent nature of the relative strength concept, the majority of these stocks have chart patterns that are either already in strong uptrends or in a few weeks consolidation along recent highs. This underlying bullish tone qualifies these stocks as “leaders” with high potential for out-performing the broader market.

Often these leading stocks that breakout to New Highs from a sound consolidation pattern, (especially in response to a strong earnings report), have gone on to be big winners during the more bullish phase of the market cycle between October and April.

Examples of Leaders “Revealing” Themselves

An excellent example of this is Amazon.com (AMZN) back during the summer correction of 2010. AMZN was bucking the broader market’s weakness during the month of August, therefore exhibiting strong relative strength worth monitoring for a potential breakout above its multi-month resistance along the $130-level. Come early September (Labor Day) when the Summer Doldrums typically start to show signs of ending, AMZN was one of the first stocks to pace the market higher, rallying as much as +43% or 55 points into the year's end.

Another great example reinforcing the importance of focusing your time on relative strength leaders during summer corrections is Netflix Inc (NFLX). Again during 2010, NFLX was one of the first stocks moving into New High territory come September. Its price then went on to double during the next 9-months.

In 2011, the summer correction lasted a bit longer than usual, probing into the early days of October before staging a strong rally. SolarWinds Inc (SWI), a leading software company with strong earnings growth was on our Focus List and poised for a breakout to New Highs. The breakout happened in late-October with a positive reaction to earnings and SWI has nearly doubled in price during the last 9-months and remains a leader atop our Focus List today.

Tying It All Together

The Summer Doldrums have proven historically to be a seasonal period that should be respected and treated with a more cautious approach. However, while not fully committed to positions, the market’s corrective action during that time should still be monitored closely. What develops on the charts in relation to the prior year’s “summer range” has been a key indicator for determining larger cycles in play.

The summer has also shown to be one of the best times for many stocks to carve out some strong bases and consolidation patterns from which they can potentially breakout from in the latter half of the year. Many times you can narrow down your choices by focusing on those "leaders" that breakout into higher ground in response to a strong Q3 earnings report.

Our Liquid Momentum Focus List can aide every investor in easily identifying those future leaders and uncovering big opportunities, all the while, still managing the occasional summer escape to the beach!

The Liquid Momentum report can be found on the Investing & Trading menu. On Live In Play, all of the Liquid Momentum context can be searched for, and have alerts generated by the "LQDXX" ticker. Comments or suggestions can be emailed to liquidmomentum@briefing.com.

-- Scott Smith, CMT, Sr. Technical Analyst