What Mid-Cap Stock Strength Means for Q4 S&P Returns

The following is a reprint of the market commentary from the October 2016 edition of The Option Advisor, published on September 22. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- click here.

While it might not attract the same volume of media or investor attention as its big-cap and small-cap counterparts, the S&P MidCap 400 Index (MID) has proven, over the years, to be worth watching as a stock market bellwether in its own right. And so it's intriguing to note that, as of the close on Thursday, Sept. 22, MID was sitting on a year-to-date gain of 11.8% -- effectively dwarfing the S&P 500 Index's (SPX) advance of 6.5% so far in 2016.

So, as we prepare to enter the fourth quarter of a year that has proven to be a wild ride for investors, what can we glean from MID's mighty outperformance relative to the reliable benchmark of the S&P 500?

Looking back to 1992 (our first full calendar year of MID price data), Schaeffer's Senior Quantitative Analyst Rocky White looked for previous instances where MID and the S&P were both positive through the first three quarters of the year, with MID outperforming. As it turns out, there have been 10 previous instances -- and in nine of those cases, the S&P turned in a positive fourth-quarter performance. Compared to the 14 "non-signal" years, the S&P's average fourth-quarter return was higher by nearly a full percentage point.

What's more, the current MID/S&P relative strength setup lends itself to a low-volatility fourth quarter. That higher-than-usual average quarterly return cited above is based on a lower average positive return and a smaller average negative loss, with the standard deviation of returns checking in at just 4.90% -- compared to 10.47% in the "Other Years" column.

The fourth-quarter forecast looks equally promising for MID based on this historical data, with 90% of previous such returns landing in the positive column -- although the index's average return is actually ever so slightly lower in years where it's leading the S&P through the end of September. In any case, this analysis would seem to suggest the cards are stacked in favor of a positive, low-volatility fourth quarter for both MID and the S&P.

To add another dimension to this analysis, there have been four previous years like this one, where the relative strength of MID vs. the S&P has been 1.04 or greater (meaning it outperforms by 4% or better) heading into the fourth quarter. All four of those years have yielded positive fourth-quarter results, with average returns much higher than usual for both MID and the S&P, and the low-volatility environment remaining intact.

With this bullish data backdrop in mind, traders should take note of the following price points (and the surrounding "zones") as levels to watch on MID, which closed Sept. 22 at 1,562.94, going forward. Overhead levels could reasonably act as resistance, and sustained advances beyond any of these could be considered signs of deep-seated technical strength. Conversely, breaks below any of the potentially supportive price points below MID's current perch should be watched with caution for signs of a deeper pullback.

• 1,600 is not only a round century level, but it's also roughly quadruple the 2008-2009 lows around 400.
• 1,581 is the site of intraday highs for MID on 9/6/2016 and 9/7/2016.
• 1,551.28 marked the site of the 6/23/2015 intraday high.
• 1,540 has alternately acted as support and resistance since March 2015, with MID frequently "catching its breath" in this area before embarking on its next directional move.
• 1,538.44 represents a 10% year-to-date gain, and we've often noted that these "round-number returns" from major benchmark levels can act as support or resistance.
• 1,506.90 is where the 120-day moving average closed on 9/22/2016.
• 1,486.58 represents a 20% gain from the 2/11/2016 closing low.
• 1,452.44 was MID's 2014 year-end close.
• 1,445.81 marked the site of the index's 200-day moving average at the close on 9/22/2016.
• 1,422.90 represents a 10% pullback from the aforementioned early September 2016 highs.
• 1,398.58 was MID's 2015 year-end close.
• 1,398.34, in addition to roughly coinciding with the index's year-to-date breakeven level, marks a 50% retracement of MID's 2016 intraday high and low.