One down…one to go.
Over the last half-century, August and September have historically been the worst months for market performance. While the stock market was down across the board for August, all the major indices closed well off their lows earlier in the month. The most significant difference in the market when comparing this August with August of 2022 was the reaction to Jerome Powell's Jackson Hole speech. Last year, Chairman Powell offered an extremely pessimistic and unexpected outlook regarding fed policy, causing the S&P 500 to give up 6% over the month's final week. Although Chairman Powell did not offer much in the way of dovish comments at this year's Jackson Hole speech, he was not very hawkish either, allowing the S&P to claw back and gain about 3% over the last week of August. Although Powell's commentary was not too hot nor too cold, it continues in the recent history of the Fed, painting a confusing policy picture for investors. More on our friends at the Fed later.
Turn Back the Clock-2021 Edition Part Deux
In our September 2021 outlook, we presented a market study showing the extremely bullish forward performance of the S&P 500 when the index was up more than 15% through August. 2021 represented the 15th time since 1950 that the S&P was up more than 15% through the end of August.
Historically, the August Indicator represented a relatively reliable positive return for the S&P over the next four years. But as the updated chart below shows, the S & P has been flat since the end of August 2021.
In last year's newsletter, we noted the weakness seen after the 1961 and 1989 August Indicators were due to specific events. The market weakness in 1962 was attributed to the May Break of '62, or what many call the 'original flash crash.' The weakness in 1990 was attributed to the invasion of Kuwait by Saddam Hussein and the subsequent Gulf War. History will likely attribute the weakness in 2022 to the hyper-aggressive policy of the Fed.
While the S&P 500 has returned almost 14% over the last year, ending the month of August, this return was less robust than what the market experienced coming out of 1962 and 1990. Again, we attribute this lack of historical follow-through to the highly aggressive fed policy over the last 18 months. Still, we believe the market should continue to work hard to get back on track. However, as we will discuss below, the extremes of Fed Policy will continue to impact returns.
Understanding the Fed at Current Levels
Since March 2022, the Federal Reserve has raised rates 11 times in 18 months, including four consecutive meetings with 0.75% increases. At the same time, the Fed has been aggressively raising rates; they have also been just as aggressive in running off their balance sheet.
September will be the twelfth consecutive month that the Fed will have run off $95 billion in Treasury and mortgage holdings from their balance sheet. Most investors don't realize that each monthly runoff represents roughly a 0.50% increase in the federal reserve rate, making it almost impossible to truly understand where the actual level of the fed rate sits. It's the exact opposite of where rates were when the Fed was sitting on 0.00% and buying $125 billion of bonds per month. We must assume that the real Fed rate is currently higher than the 5.50% the Fed indicates.
Even after all their actions, the Fed continues to stand by its mandate of 2% inflation before it looks to make policy less restrictive. This will likely be another example of the Fed being too late to start and stop with their policy. But, issues are beginning to show up in the economy as the cost of borrowing has become highly restrictive and cumbersome.
Real Estate - the average monthly payment on a 30-year fixed mortgage in the US has reached a record of $2,700 per month as borrowing rates have increased to three-decade highs. We currently see the most significant gap on record between the monthly price of owning a home and the cost of rent. The good news is that most homeowners hold mortgages with rates at about half of current levels. Since moving is very cost-prohibitive, we continue to see the supply of housing inventories near record lows, forcing most real estate activity to come from new construction. Less supply is keeping housing prices fairly stable and helping avoid a 2008-type meltdown. However, less home sale activity does negatively affect the economy.
Car Sales - Gone are the days of 2021 and early 2022 when lots at auto dealerships were sparsely populated with both new and used cars. Almost every lot in Florida seems to now overflow with vehicles as car loan rates approach double digits. As with real estate, there is a trickle-down effect throughout the auto industry when sales slow and prices must drop.
Loan Delinquencies - auto loans, credit cards, and consumer loan delinquencies have risen significantly over the last two years, and their respective loan balances are at the highest levels we have seen over the past decade. However, the excess savings Americans built up during COVID-19 still remain at decent levels (although about half of what they were a year ago) has cushioned the impact. But with the October 1st deadline of the moratorium on college loan repayments finally being removed after three years, 43 million borrowers could certainly feel the impact and cause delinquencies to increase even further.
These are all early signs of economic stresses building in the economy, which unless the Fed begins to address, has the potential to cause significant disruptions in the economy and stock market at some point in 2024. As usual, we will be watching the Fed statements closely.
September Outlook
Although most indices year to date are positing positive returns, the overall market remains the most bifurcated we can remember since the Tech Bubble. Based on its performance through the end of August, roughly 70% of the stocks inside of the S&P 500 have returned less than the average itself. This has been an ongoing problem for most of the year as the mega-cap tech space, driven by the frenzy in artificial intelligence, has dramatically outperformed.
There was an attempt by the market to broaden out in June and July, but this was quickly reversed in August as bond yields began to rise and fears grew that the Fed would become more aggressive again. This is much of the same that has held back the market since the December 2021 Fed minutes were released on January 5th last year.
Over the last month, several of our internal market indicators have begun to weaken. Our money flow indicator (which tracks the % of money flowing into stocks) saw a decrease of roughly 10% during August. At the same time, a 10% drop is not overly concerning since the indicator is coming off some of the highest levels we have seen, but it will be important to see this indicator stabilize in order for stocks to rally. But, if our money flow indicators become bearish, we will be ready to pivot and tilt to a more defensive portfolio recommendation for our clients.
With the S&P Index outperforming roughly 70% of its constituent indexes, it has been driven by only 27% of stocks showing positive relative strength. As previously mentioned, they are almost all companies within the technology sector. The positive side to this indicator being at such an extreme level is that it would be quite challenging for this relative-strength indicator to get much worse. This leads us to believe that we will start to see signs of the market broadening out in the coming weeks.
Looking at the Presidential Cycle pattern over the last 72 years, historically, we expect the beginning of September to provide a bounce before giving away to weakness to close out the month. This weakness is almost always associated with aggressive rebalancing by asset managers and mutual funds to close out the 3rd quarter.
But in our opinion, any September weakness should be viewed as an opportunity to get aggressively long into the end of the year. The pre-election year market, as shown above, historically closes out the year with a significant rally. This rally is traditionally stronger following a midterm year which included a bear market, as was 2022. Also, this rally is usually stronger when it occurs during a president's first term in office.
So, for September, we expect the weakness seen in August to continue, but this weakness should be viewed as transitory and should lead the market to an important low near the end of the month. This could set up to be a significant low to buy into and move some cash off the sidelines and into stocks.