September is Stocks' Cruelest Month
08/13/2013 11:00 am EST
The market is due for a correction. But even if it gets one, stocks should resume rallying later this year once the immediate crises are addressed, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
Since 1971, September has been by far the worst month of the year for US stocks. The average September return on the Standard & Poor's 500 Index (SPX), from 1971 through 2012 is a loss of 0.52%, according to the Stock Trader's Almanac.
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, 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 head of the pack.)
Now whether or not you believe in historical stock market seasonal patterns, the September data is a useful warning flag. If the numbers simply draw your attention to September and the likely trends this year, they've 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.
And that's 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.
The immediate threat
So why do I think September has such downside potential? The Federal Reserve, for one, and the political parties occupying opposite ends of Pennsylvania Avenue in Washington, DC.
The Federal Reserve's Open Market Committee meets on September 18, and at the top of its agenda is the matter of when to begin reducing the central bank's program of buying $85 billion a month in Treasurys and mortgage-backed securities. And that's making the stock and bond markets nervous. The fear is that any reduction in the Fed's monthly purchase will cause long-term interest rates to move higher, suppressing US growth.
The Fed hasn't done a particularly effective job at allaying those fears because, in my opinion, it hasn't 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's the Fed's read of the economic data? It's 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 FOMC meeting in October.|pagebreak|
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 noted that fiscal policy was acting as a drag on economic growth. But the Fed also said it expected economic growth to pick up in the second half of the year and pointed out that downside risks had diminished since the fall of 2012.
To me, that sounds like a Federal Reserve moving toward tapering its purchases. And a spate of speeches from Federal Reserve officials last week 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 hasn't yet begun to reduce its purchases, it locks investors in place.
The likelihood is that an initial reduction from $85 billion a month to, say, $70 billion, won't have a huge effect on the prices of stocks and bonds, but no investor really knows. But what's the upside of getting out in front of any actual Federal Reserve announcement?
Replay of fiscal cliff debacle?
Especially since the talk out of Washington points to a replay of last year's fiscal cliff debacle. 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 they won't vote to raise the debt ceiling without big cuts to discretionary spending programs that already have been 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 shut down.
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 exceed the debt ceiling until sometime in October.
Right now the two sides aren't even talking, so it looks like we'll 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 shut down.
If you look back to the run-up to November/December/January fiscal cliff "crisis," the market wasn't amused. The S&P 500 fell 7.2% in the two months from September 13 to November 15. This time around we've got two crises on the same timetable—the budget and the debt ceiling—and it's hard to imagine that the market wouldn't have a similar negative reaction.|pagebreak|
On the sidelines
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 isn't possible to predict what will happen, 2) it's hard to imagine the market climbing as these two crises come rumbling down the track, and 3) it's tough to predict how far the market might fall.
My own prediction is that the market will stage a correction here. By definition, that's a drop of 10% or more. I think that's 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-September 2011 13.2% drop to find an honest-to-goodness correction. Rallies need corrections to reset prices, build new bases for further advances, and convince money on the sidelines that NOW is the time to buy. We haven't had one of these events in a long time and it's reasonable to think we're due for one.
On the other hand, I don't think the indicators are pointing to anything much worse than a correction for now—and there's some chance we won't get to the 10% threshold, but will instead see another 7%, or so, drop.
First, while we're due for a correction, we're not way, way overdue. The average time between corrections in bull markets, since 1932, is 29.8 months, according to InvesTech Research. That's one every 2.5 years and we're currently two years away from the September 2011 correction.
Second, even with the current very long rally to all-time highs, US stocks aren't spectacularly overvalued. They are overvalued based on market history: On August 9, the price to earnings ratio on US 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 P/E ratio is higher than about 77% of past readings.
The good news is that degree of overvaluation isn't at the extreme level we usually see before a drop greater than 10%. (The bad news is that P/E 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.)
And, third, US stocks have the advantage that there isn't a really attractive alternative to dollar-denominated equities. It's harder to take money out of US stocks when European and emerging market equities don't offer an attractive alternative. (And whatever their recent performance, the volatility and track record of Japanese stocks make them just too scary to many US investors.)
In my opinion, a bigger than 10% drop waits on a combination of even higher US equity prices, an economic slowdown that takes a bite out of projected earnings, and a weaker dollar that is less attractive than alternative currencies.|pagebreak|
The road ahead
So what am I expecting for September?
General nervousness, of course. That might be good for a 7% retreat all by itself.
A stronger dollar if the Fed indicates on September 18 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'd look to add to positions in Japanese equities on that kind of weakening of the yen. I'd hold off on purchases of commodities and commodity stocks until I saw how far a strong dollar bounce might go.
I'd also expect another retreat in bonds and other income-related assets, such as REITs (real estate investment trusts) and bank stocks as investors overreact 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.
Another budget/debt ceiling crisis obviously wouldn't do wonders for the dollar. Events could raise the prospects for another downgrade of US debt from the credit rating companies, and investors with the slightest doubt about the full faith and credit of the United States won't rush to buy Treasurys or other US 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 US politicians would destroy US 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 won't react to the worst of their imaginings.
Any decline is likely to be tempered, too, by investors and traders who think that US 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 selloff, on fears of a modest rate of Fed taper on asset purchases, as an overreaction. And I think a relief rally in late November or December would greet any news that Congress and Obama have found some way—even one as stupid as the sequester solution to the last debt-ceiling crisis—out of the current impasse, short of mutually assured destruction.
I don't 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'd 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.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund's portfolio here.