Get Ready For September Madness
Since 1971, September has been by far the worst month of the year for U.S. stocks. The average return on the Standard & Poor’s 500 Stock Index for September from 1971 through 2012, according to the Stock Trader’s Almanac, is a loss of 0.52%. Considering that only three other months show an average loss of any size over that period and that the second worst loss is the 0.1% turned in by February, September sticks out like a very sore thumb. (October, feared as the month of crashes, on the other hand, shows an average return of 0.74% in that period. Not as good as December’s 1.7% return, of course, but then December is the leader of the pack.)
Now, whether you believe in historical stock market seasonal patterns or not, the September data is a useful alert. If the numbers simply draw your attention to September and the likely trends this year, they have served an important function. Because on projections of current news, September shapes up as a volatile month with way more downside risk than upside potential. September sure looks like a month for taking less risk rather than more, for having more money on the sidelines rather than less, for thinking about protecting gains and principal rather than rolling the dice.
That is especially the case, because it is extremely likely that any fears that take stocks lower in September will have passed by October or November. I think investors would like to have some cash on hand as we flip the calendar page to October just in case September lives up to its downside potential and creates a bargain or two.
So why do I think September has such downside potential? The Federal Reserve and the parties that occupy opposite ends of Pennsylvania Avenue in Washington, D.C.
First, the Federal Reserve. The Open Market Committee of the U.S. central bank meets on September 18 with the decision on when to begin reducing the bank’s program of buying $85 billion a month in Treasuries and mortgage-backed securities at the top of its agenda. Right now, that makes the stock and bond markets nervous. The fear is that any reduction in the Fed’s monthly purchases will cause long-term interest rates to move higher and that will lead to a reduction in U.S. growth.
The Fed has not done a particularly effective job at allaying those fears — in my opinion because it has not wanted to. Letting market fears push interest rates gradually higher and asset prices gradually lower would make an actual transition to a slower rate of purchasing — or to the eventual end of the entire program of buying — easier for the Federal Reserve by taking some of the air out of asset prices over a longer period of time rather than all at once. The Fed’s repeated assertions that its decision will be based on the economic data has served to keep the market on edge, and that may be exactly what the Fed wants.
What is the Fed’s read of the economic data? It is not exactly crystal clear, but I think the Fed is saying that the economy is strong enough that a reduction in purchases is likely either in September or at the Open Market Committee meeting in October. In July, after noting that the economy had expanded at a modest pace and that labor market conditions were improving with strength in the housing market, the central bank also said that fiscal policy was acting as a drag on economic growth. But, all in all, the Fed continued, economic growth will pick up in the second half of the year, and downside risks to the economy had diminished since the fall of 2013.
To me, that sounds like a Federal Reserve moving toward tapering its purchases. Last week, a spate of speeches from Federal Reserve officials that, on average, added up to belief that the taper had to begin sooner rather than later carried weight with me, because the verbiage came from both advocates of an early taper and those members of the Open Market Committee who had argued in the past for a later taper.
As long as the Fed is talking about a taper but has not yet begun to reduce its purchases, it locks investors in place. The likelihood is that an initial reduction from $85 billion to, say, $70 billion a month will not have a huge effect on the prices of stocks and bonds, but no investor really knows if that is the likely dimension of the Fed’s first move or what the effects might be.
What is the upside, under those circumstances, of getting out in front of any actual Federal Reserve announcement?
Especially since the talk out of Washington is about a replay of the fiscal cliff, let the U.S. default because we will not raise the debt ceiling, no budget, shut it down confrontations of the last half of 2012. A substantial number of Republicans in the Senate and, more decidedly, the House have said no budget or continuing resolution unless Democrats and the White House agree to defund or repeal President Barack Obama’s signature health care program, the Affordable Care Act, aka Obamacare.
The same Republicans have said no increase in the debt ceiling without big cuts to discretionary spending programs already reduced by the automatic reductions in the sequester. Democrats in the Senate and the White House have shown no inclination to agree, and indicate instead that they believe that Republicans will take the blame if the government actually does shutdown.
Without a budget, or at least a continuing resolution, the government will run out of spending authority at the end of September. The Treasury looks like it will be able to juggle accounts so that it won’t will not exceed the debt ceiling until sometime in October.
Right now, the two sides are not even talking, so it looks like we will either go down to the wire before there is a deal or, more likely, go past the deadline and only see a deal once the government has actually had to shutdown.
If you look back to the run up to the November/December/January fiscal cliff “crisis,” the market was not amused. The S&P 500 fell 7.2% in the two months from September 13 to November 15.
This time around, we have got two crises on the same timetable — the budget and the debt ceiling — and it is hard to imagine that the market would not have a similar negative reaction. At the least, the two crises will, like the Federal Reserve’s taper decision, suggest that the smart play is to move money to the sidelines since: (1) it is not possible to predict what will happen; (2) it is hard to imagine the market climbing as these two crises come rumbling down the track; and (3) it is tough to predict how far the market might fall.
My own prediction is that the market will stage something like a correction here. By definition, a correction is a drop of 10% or more. I think that is the likely dimension of a September drop on worries about the Fed and a Washington deadlock based on the dimension of the drop in 2012 on the fiscal cliff fiasco, and the length of time this rally has run without even a 10% drop.
I can go back to September-November 2012 for that 7.2% decline, or back to March-May 2012 for a 6.6% pullback, but I have to go all the way back to the July to September 2011 13.2% drop to find an honest to goodness correction.
Rallies need corrections to reset prices, to build new bases for further advances, and to convince money on the sidelines that NOW is the time to buy. We have not had one of these events in a long time and it is reasonable to think we are due for one. On the there hand, I do not think the indicators are pointing to anything much worse than a correction for now — and there is some chance we will not get to the 10% threshold but, instead, will see another 7% or so drop.
First, while we are due for a correction, we are not way, way over due. The average time between corrections in bull markets since 1932 is 29.8 months, according to InvesTech Research. That is one every 2.5 years, and we are currently two years away from the September 2011 correction.
Second, even with the current very long rally to all time highs, U.S. stocks are not spectacularly overvalued. They ARE over-valued based on market history: On August 9, the price-to-earnings ratio on U.S. stocks was 18.62 times trailing 12-month earnings. The average on the S&P since 1871 is 15.5, according to Yale’s Robert Shiller. So, the current PE ratio is higher than about 77% of past readings.
The good news is that degree of over-valuation is not at the extreme level we usually see before a drop greater than 10%. (The bad news is that PE ratios of this level are associated with very, very modest long-term returns going forward. If you used Shiller’s cyclically-adjusted-price-earnings (CAPE) ratio — currently above 23 and, therefore, higher than 90% of CAPE readings since 1871 — the historical numbers say investors should look for average annual real (that is above inflation) returns of just 0.9% over the next ten years. (CAPE uses average inflation-adjusted earnings for the trailing ten years in its calculations in order to smooth the business and market cycles.))
Third, U.S. stocks have the current advantage that there is not a really attractive alternative to dollar-denominated equities. It is harder to take money out of U.S. stocks when European and emerging market equities do not offer a compelling alternative. (And whatever their recent performance, the volatility and track record of Japanese stocks make them just too scary to many U.S. investors.)
In my opinion, a bigger than 10% drop waits on a combination of even higher U.S. equity prices, an economic slow down that takes a bite out of projected earnings, and a weaker dollar that is less attractive than alternative currencies.
So what am I expecting for September? General nervousness, of course. That might be good for a 7% retreat all by itself.
Also a stronger dollar if, on September 18, the Federal Reserve indicates that a taper of asset purchases is due sooner rather than later. A stronger dollar would put an end to the recent rally in commodity and gold prices. On a technical basis, the dollar looks oversold and ready to bounce back against the yen and against commodities. I would look to add to positions in Japanese equities on that kind of weakening of the yen. I would hold off on purchases of commodities and commodity stocks until I saw how far a strong dollar bounce might go.
Another retreat in bonds and other income related assets, such as REITs (real estate investment trusts) and bank stocks as investors over-react to an impending taper. I think income investors, and especially bond owners, have been beaten up sufficiently recently so their first reaction on anything like bad news from the Fed is likely to be to sell.
A budget/debt ceiling crisis in late September/early October will not do wonders for the dollar obviously. Events could raise the prospects for another downgrade of U.S. debt from the credit rating companies, and investors with the slightest doubt about the full faith and credit of the United States will not rush to buy Treasuries or other U.S. dollar-denominated assets. But my suspicion is that the damage will be less than the rhetoric might lead you to expect. It is frankly unimaginable to most investors that U.S. politicians would destroy U.S. credit in a search for political advantage. So, until the markets see such destructive stupidity actually at work, I think income investors and dollar traders will not react to the worst of their imaginings.
Any decline is likely to be tempered too by investors and traders who think that U.S. asset prices will climb again in November and December — as they did in 2012 — once the immediate crisis passes.
With time, I think the bond markets will come to see their initial sell off on fears of a modest rate of Fed taper on asset purchases as an over-reaction. And assuming that Congress and the President find some way — even a way as stupid as the sequester solution to the last debt ceiling crisis — out of the current impasse, short of mutually assured destruction, I think we get a relief rally again in late November and December.
I do not think this magnitude of a correction and subsequent bounce solves the long-term problems in global financial markets caused by massive expansion of central bank balance sheets. It just leaves them for another day.
But, until that day arrives — with its requirement for the aggressive pursuit of safe havens — I would deal with the coming September madness by selling losers and taking profits in my portfolio now so that I had cash available for bargains in October and November.
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