The first day after Labor Day, markets declined 2%. It was the fifth worst September start since 1928.
But as many of our readers know, we flagged the period from July 31to Election Day as generally tough. The tribulations of early August were a stark reminder of historical election year dynamics:
While seasonality says stocks generally struggle between now and Election Day, the fundamental reality is this “weak seasonality” is taking place during an extremely strong stock market this year. It seems many people already forgot the S&P 500* has risen seven out of 2024’s first eight months. In the past five years, only 2021 displayed similar strength. Even with the volatility in early August, the S&P 500 still gained for the month – perhaps the most impressive feat of the year.
Let’s keep in mind we’re in a very strong market. Therefore, meaningful dips between now and Election Day should be viewed as potential opportunities.
The problem is we don’t know when these dips will happen. However, three fundamental catalysts in the near term will provide some of that data and we can glean how markets will react.
The first is employment. A strong jobs report relative to the consensus outlook of 165,000 jobs added could see the Federal Reserve backpedal on interest rate cuts. If jobs added came in around 110,000 to 150,000, a “soft landing” would be the narrative.
Next is the core consumer price index, which measures changes in consumer prices, excluding food, shelter, energy, and used vehicle prices. If it came in greater than a 0.2% month-over-month increase, markets might pull back. If core CPI is below 0.2%, it confirms inflation is still falling like a rock (our longstanding view), which markets likely would view favorably.
Last is the Fed. It would be hawkish if the Fed cut rates by 25 basis points but gave no indication of future cuts. If the Fed overreacted and cut by 50 basis points, this would likely be viewed as panic. The more positive, dovish path would be to announce a 25-basis-point cut and more coming in the future.
With the fundamental catalysts front loaded, we can perhaps understand the equities weakness in early September (markets look forward and endured the weaknesses).
Another vitally important metric to watch is the CBOE Volatility Index (VIX), which is often dubbed the market’s “fear gauge.” It measures market expectations of near-term price changes in the S&P 500, averaging 19.3 annually since 1991. Remember when the VIX went up to 70 intraday during the early August volatility?
Last week VIX surged 33% up to 20.7 on Tuesday alone. Additionally, the VIX term structure inverted, meaning the one-month contract had a higher reading than the contract expiring in four months. This inversion is another sign of higher volatility.
Without additional fundamental information, we can’t place a finger on why VIX jumped so much. But we need to pinpoint when it peaks, as it’s a sign of overall fear topping out.
We conducted some seasonal analysis of VIX to understand history. The data is pretty consistent. Since 1990 in election years, the VIX peaks in late October:
Going back to 1928, volatility peaks in early November:
If pure volatility seasonals were to play out, we can expect VIX to not be at or below 15 until late October. This would be supportive of stocks finishing strong into the end of 2024. But it’s important to illustrate the potential near term treachery of the next eight weeks.
Keep in mind, the Fed is dovish and focused on keeping labor markets strong. Combined with softening inflation, that creates an implicit “put” on equity markets.
A Tale of Two Markets
Much of the increased volatility recently is a result of low liquidity. That issue should begin to evaporate as we get further into the fall.
This natural seasonal effect is another reason it’s important for us to point out near-term risks, but also not put too much stake in the overall trading patterns at the beginning of September. This phenomenon was reflected perfectly in August too. Interestingly, MAPsignals’ trusty Big Money Index (BMI), a 25-day moving average of “big money” investor netted buys and sells, held stable, despite the big dip in the first week of August:
Now let's rewind a little bit. The below chart shows the distribution of unusual buying and selling from Aug. 1-6 on the left and the same from Aug. 7-30. It’s a tale of two markets:
New small- and mid-cap leadership is forming. Looking at the highest ranked stocks, there's a clear pattern of buying in companies with market capitalizations below $20 billion (nine of the top 10 stocks# bought unusually since Aug. 7):
We've been discussing the great setup for small- and mid-cap stocks for months now. The above chart is illustrative of the market once again being ahead of the popular news cycle. With interest rates nearly certain to commence falling on Sept 18, there’s an additional wind at the back of smaller companies in the form of lower financing costs that will fall directly to their bottom lines.
Furthermore, consumerism should also benefit small- and mid-cap stocks. It’s already happening. In July there was an epic rally of 11.6% for the small-cap-heavy Russell 2000 Index^, only for it to reverse in the first week of August. But notice the 8.3% growth since:
Even more interesting is the rate of change from heavy “big money” selling to virtually none:
There are bound to be unsettling near-term actions. What happened in August is most likely going to happen again. It might be happening now.
But let’s remain focused on the prize of Dec. 31. A short-term, emotional reaction is not going to be helpful, especially since the fourth quarter is historically the strongest time of the year. So, let's see what we can glean from similar periods in history when we zoom out.
Our friends at MAPsignals looked back to 1990 to identify similar times where selling had a wicked peak (a minimum of 100 sell signals) then plummeted to just 10% or less of total signals 10 days later. There were only 48 prior instances.
The S&P 500’s forward returns are solidly positive after volatile, emotion-driven market actions. Better yet, the win rates for positive returns were extraordinarily high:
We could be pessimistic knowing we just entered the seasonally weakest month of the year and an election fraught with anxiety is only weeks later. However, if we force ourselves to look to the end of the year, there's plenty of cause for optimism. This latest vacuum of selling just adds to the thesis. There's also plenty of upside possibility in the fourth quarter, once we get past the immediate potential dangers. We just need to focus on the positive horizon forming ahead.
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*Past performance does not guarantee future results.
* The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.
# Some Cornerstone client accounts own positions in CPRX, MNDY, MMYT, HALO, and DOCS. Daniel Milan does not own them in personal accounts.
^ The Russell 2000 Index is a stock market index measuring the performance of the 2,000 smaller companies in the Russell 3000 Index and is widely regarded as a bellwether of the U.S. economy.
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