Leave it up to the Federal Reserve to ruin the party. All the major indices that we follow had been posting positive returns for August up until Jerome Powell’s Jackson Hole speech on the morning of August 26th. These comments from the leader of our out-of-touch Fed opened a trap door under the market and led to significant drops by more than 5% over the last four trading days. These trap doors have been a characteristic of the 2022 market, a period within each month where a comment by the Fed or a data point such as inflation leads to a substantial pullback over consecutive days:
These periods of volatility that we have seen so far throughout 2022 are almost the opposite of the 2021 market and is the first period of extended volatility that we have seen since the spring and summer of 2011. Between May and September of 2011, the S&P 500 dropped more than 18% as the market dealt with several issues, including the European Debt Crisis, the US Debt Ceiling & debt downgrade, and lack of Fed support after QE1 was completed. Again, the play that is the market always remains the same; it’s the players that change. In 2022, we have had to deal with inflation, supply chain issues, and a lack of Fed support after QE4 was completed. It remains to be seen if the market can turn around as quickly as it did in 2011.
Turn Back the Clock- 2021 edition
In our September 2021 market outlook, we presented the following comments and data about having positive market history on our side:
For 2021, the S&P 500 Index is up roughly 20%. This is the 15th time since 1950 that the S&P has closed out the first eight months of the year with a gain of greater than 15%. This market performance has traditionally represented a positive market signal for the rest of the year.
In twelve of the previous fourteen years, when the market was up more than 15% through August, the market posted an average return of 7.35% for the remainder of the year. Only the markets of 1986 & 1987 were outliers where market strength was reversed during the final four months of the year. For as bad as the last half of 1987 was, the S&P did end positive on the year.
Looking out even further, this type of market strength has been an indicator of strong stock market returns for the next four years. See chart:
Forward Performance of the S&P 500 When the Index Is Up More Than 15% Through August (Since 1950)
What this means for 2022
While the last four months of 2021 followed the expected trend and closed on a strong note, the action of the S&P 500 from the end of August 2021 to the end of August 2022 has produced one of the few negative return periods from this study. With a -12.55% return over the last year. The 2022 market resembles the markets of 1962, 1988, & 1990 as negative outliers in this study:
Updated Forward Performance Table Including 2021
One essential item to take from this study, after the second year, is the market periods in this study all post positive gains from their inception by an average of 22.37%, which includes the three periods that our current market most closely resembles. Moving forward after the first year of the study, almost all the data is positive in performance.
Mid-term Election Years
We can drill this data down even further when looking at the negative years in 1962 & 1990, both of which were midterm election years:
To start the year, the S&P fell by 28.23% before making its midterm market low in June. Most of the weakness was attributed to the “May Break” of 1962 or the original flash crash, which had investors believing a second great depression was upon them. Surprisingly from the end of August 1962, the S&P went on to average 13.75% over the next three years.
For the first seven months of the year, the S&P was flat, but that quickly changed when Saddam Hussein invaded Kuwait on August 2nd. The rise in oil prices and geo-political uncertainty caused the S&P to drop 17.42% over the next three months before finally making its midterm market low in October 1990. Similar to the market response after the 1962 low, the S&P offers roughly 13% annual returns for the next three years.
While this year has been and will continue to be challenging for some time, this historical data again points to better days. And if the S&P over the next year keeps with the trends of this study, we should assume that by the end of August 2023, the S&P should be trading above 4,522.68.
September to Remember or Forget
Since 1950, September has been the worst month of the market across the board. Although a midterm election year brings slightly better performance, historical monthly returns have consistently been to the downside. Over the last 15 years, September maintained its title as the worst month for the S&P in 2021 with an average -0.84% return, including a -4.76% last September.
The one significant benefit of September’s overall poor performance is that it usually leads to the start of the year-end rally. Below is the Stock Trader’s Almanac STAAC seasonal chart that averages the 1-year seasonal pattern from all years between 1946-2001, the second year or midterm year, the 4-year Presidential Election Cycle, and the Decennial Cycle for the second years of each decade.
The averaging of this historical data presents September as the month that the market should finally be able to bottom and rally out. This is not much different than what we would expect from our historical midterm patterns and follows the idea that the lows for 2022 have been realized. So, while September has historically been the weakest month, it also usually provides the best opportunity to trade out.
Currently, it seems the market continues to be a mishmash of conflicting indicators and expectations, all under the control of the Fed.
On the positive side, our Daily Money Flow indicator and our “weighting” system posted record levels in August, which remain highly elevated versus historical averages. Money flows for the S&P 500 reached almost +90% in August, against a roughly long-term average of +49%. In the past, these types of money flow ‘thrusts have always led to higher prices. At the same time, using money flow and relative strength indicators, our ‘weighting’ model reached a record +78.53% in August, again crushing the long-term average for this indicator. These indications have been highly bullish since the third week of January and don’t really appear to be slowing down, even with the weakness we saw to end the month.
The negative for the market rests with the Fed and their updated outlook provided by Chairman Powell at Jackson Hole. To us, the comments from Powell and, of course, all the other experts at the Fed have focused on controlling inflation, raising rates higher and for a more extended period, and managing the pain of normalizing monetary policy.
To us, the Fed’s outlook almost sounds like an overreach in the opposite direction of the underreach they maintained in 2020 & 2021. The inability to recognize inflation growth or that their policies could lead to a spike in inflation has the Fed working overtime, trying to correct their mistake.
The Fed’s comments at and after Jackson Hole have led to an expectation of higher rates moving forward, including another 0.75% increase at the September meeting. This comes at a time when the Fed increased their balance sheet runoff from $47.5 billion per month to $95 billion per month on September 1st. It appears that the Fed has learned nothing or doesn’t remember the issues caused by raising rates while running off their balance sheet in 2018. This all continues to point to massive overreach by the Fed, considering there is no need at this time to run off their balance sheet aggressively. In our opinion, the Fed’s actions are a bit too political in front of the midterm elections, trying to crush inflation before citizens head to the polls in early November. Our gut feeling on the Fed is that their current stance will soften significantly after the November elections, as the Fed will pivot to worrying about economic weakness more than the strength of inflation.
As we work through the month of September, we would expect the market to remain extremely volatile. September is traditionally characterized by an extremely bullish options expiration week, followed by a period of extremely bearish performance the week following options expiration week, and limp into the end of the month. The FOMC meeting on September 21st could spark a strong rally or lead to more negative pressure on the market. Given the negative seasonal expectations for the month and the Fed’s massive increase to their balance sheet runoff, it will be difficult for the market to make up any ground in September. There is daylight at the end of this tunnel, and we feel September represents the bottom of the 9th or final at-bat for the Bears in this market cycle. We would look for any weakness later in the month as possibly the best opportunity we have seen since the Covid Lows to get bullish.