Four Reasons for the Surprise Stock Rally in September
September's sharp rally comes from a recipe of rather mild ingredients: Double-dip fears coming off the table, a jump in M&A activity, reasonable valuations and the need for short-sellers to cover their positions.
There's also a bit of thin air in there as well, with few of the above-mentioned factors overwhelmingly positive for the markets, which are rising during what is usually the worst month of the year for Wall Street.
Regardless, the Standard & Poor's 500 is well on its merry way to record its best September in more than 70 years and the Dow its best in 56 years.
"It is truly difficult to come up with an explanation for the breakout, which in turn makes it difficult to ascertain its veracity," David Rosenberg, economist and strategist at Toronto-based Gluskin Sheff, said in his morning note. "But the price action is undeniable and the bulls are in fact winning the battle in September, a typically negative seasonal month, after a bloody August."
Here are four factors likely responsible for the market's rise:
1. Reversing Double-Dip Fears
September's rally comes off a miserable August in which the S&P dropped 7 percent from Aug. 2-26 on fears that both housing and unemployment were getting weakerinstead of better and would lead the economy back into recession.
The market correspondingly started pricing in those double-dip fears. But incremental improvements since then have reversed that trend.
So for how gaudy the September gains look, all the market really has done is reverse the August slump and put the S&P, before Monday's rally, back to its Aug. 9 level, and even with the day's surge back to its May 14 mark.
"What we've done in September was just claw back what we gave back in August. One of the drivers was the economic data stream stopped getting worse than expected," said Art Hogan, managing director at Jefferies in Boston. "All the talk about double-dip recessions sort of went by the wayside."
2. Shorts Give Back
All that August pessimism gave rise to short-sellers, who borrow a company's shares to sell, then buy them back later in hopes that the stock falls and they can pocket the difference.
Short interest on the New York Stock Exchange rose 4.9 percent in August and 4.5 percent in the second half, which was the biggest jump since March 2009, the same month the market hit its multi-year lows, according to market research firm TrimTabs.
With all those shorts are out there, at some point they will have to cover their positions when bearish sentiment reaches a fever pitch.
"Short interest is typically a contrary indicator, so the 4.9% increase in the past month is bullish," TrimTabs wrote in its weekly liquidity review. "But we suspect many recently added shorts were covered in the past couple of weeks."
Valuations and M&A Help, But Can it Last?
3. Valuations Continue to Hold
Viewed within the prism of earnings that continue to provide positive surprises—and the full-blown beginning of third-quarters earnings season only a couple weeks off—stocks trading in low double-digit multiples are still attractive to some analysts.
"Valuations are very good, and while the economy is not robust, it's OK," David Katz, chief investment officer for Matrix Asset Advisors, said in a CNBC interview. "We're at a 27-year high in unemployment yet companies are doing very well on an earnings front."
The market's price-to-earnings ratio, when compared to what earnings likely will be not only this year but looking forward to 2011, make stocks an attractive investment after months of investors flocking to bonds, said John Stoltzfus, chief strategist at Ticonderoga Securities in New York.
"We've had a record number of surprises in the last year," he said. "Coming into another earnings season ahead that may not surprise as much to the upside but will likely not disappoint that much to the downside, the S&P now showing a trailing multiple of 13 times earnings this year and next year around 12 indicates there's room to move to the upside from here."
4. M&A Increase Gives Confidence
The market began to turn around late last month when the normally quiet August mergers and acquisitions season suddenly turned robust.
That as much as anything began to convince investors that while the macroeconomic data continued to languish, corporations were beginning to prepare for growth.
"Mergers have a lot to do with it. These companies are willing to pay three times where the stock was trading," said Dave Rovelli, managing director of US equity trading at Canaccord Adams. "Technology has a boatload of cash that these guys don't know what to do with. If they think these companies are cheap, that's giving investors a sense that there are some bargains out there."
Indeed, investors searching for the right M&A targets could make for interesting market behavior and drive some unexpected rallies.
"M&A is going to be rampant, especially in technology," Hogan said. "You want to have exposure there and you want to be facing the US exposure."
But Can it Last?
The sustainability is the big question for the rally. After all, the market has been here before numerous times this year, though pros were particularly impressed with Monday's rally.
While it lacked volume, the move put the S&P 500 clearly above its 200-day moving average, and 60 percent of the NYSE components have followed suit.
At the same time, last week saw a net inflow to equity funds, including exchange-traded funds, of $7.9 billion, according to Lipper data. It was the second week in a row that the figure for equity funds outpaced bond funds, though the ex-ETFs number continues to favor bonds.
"At some point long-term investors have to transition out of an extremely overbought high-grade corporate and Treasury market and start thinking about long-term prospects of equity markets," Hogan said. "With any kind of economic growth next year, it's probably a rational investment for long-term investors to start getting more exposure to the equity market."