For September, a Break From Selling but Not Volatility
Investors looking for a bounce after a brutal four-month run in the stock market might get it in September, but not without a strong level of volatility.
Typically Wall Street's worst month, this September comes after a 10 percent decline in the major averages from their early May highs—a technical correction in market parlance—amid a torrent of worrying economic signs, bitter battles in Washington and threats from European debt.
With signs the selloff may be taking a respite, the historic 0.5 percent average decline may not hold this time around, as a late-August rally sets the stage for a reboundas well as a roller-coaster investing environment.
"A counter-trend rally may be in the making, but it could be short-lived from the perspective of magnitude or duration," Sam Stovall, chief investment strategist at Standard & Poor's, wrote in a research note. "Until the economy offers better clues of its recovery, we advise a cautious approach."
Stovall advocates a mix of defensive stocks—such as health care and consumer staples—that show strong earnings growth prospects and dividends.
"Heightened volatility is likely to be part of 'the new normal,' in our opinion, whether you rely on ancient history or just point to the recent past," wrote Stovall, borrowing the Pimco term for the economic climate. "Who or what deserves the blame? High frequency trading, hedge funds, inverse and leveraged (exchange-traded funds), take your pick."
Strategist after strategist uses the term "volatility" to describe the September outlook. That also would be consistent with the month's historical standing as the third most-volatile of the year. Volatility also has been a hallmark of the 21st century, which has had, on average, nearly three times as many days of gains or losses of more than 2 percent than in the previous 50 years, according to S&P.
Another factor seems to be in play regarding volatility, namely the uncertainty behind what the Federal Reserve's next move will be.
Many cite renewed belief that the central bank is ready to step to the plate with another round of quantitative easing —QE3, as it is called, or the buying of assets in an attempt to generate risk-taking in the capital markets.
Counting on the Fed and Chairman Ben Bernanke to come through with more intervention is an admittedly risky bet, but some are willing to use it as an excuse to ride at least a near-term rally during a usually ugly September.
"The economist side of me is saying people are mispricing their assets if they're banking on QE3," said Dan Greenhaus, chief global strategist at BTIG in New York. "The strategist side of me says that's their problem and we should ride their coattails a little higher."
In that scenario, Greenhaus also likes more defensive plays over the long term but believes investors can use cyclicals such as consumer discretionary and technology to capitalize on the near-term moves at least until the Fed's direction is made clear.
He thinks the central bank is less likely to go with QE3 in the form of Treasurys or mortgage purchases and more likely to entertain a version of Operation Twist, a 1960s-era move to drive down long-term interest rates by selling shorter-dated securities and buying longer-dated debt.
"In a larger sense we're cognizant of the fact that meaningful upside appreciation is likely to be limited over the next couple of quarters," he said. "In the immediate term, you want to be tactically long cyclicals."
Investors indeed will be caught in a tug-of-war between an economy either flatlining or declining and growth in corporate America that still is relatively robust.
So far, trepidation about the economy is winning, with safe-haven bonds often gainingeven on days when the stock market also rallies.
"The rallies in bonds and stocks are mutually inconsistent developments, and history shows that the bond market usually gets it right," David Rosenberg, economist and strategist at Gluskin Sheff in Toronto, wrote in his daily note.
Rosenberg sees trouble ahead and advises playing commodities like gold and silver and using long positions in defensive stocks against shorts in cyclicals due to the weakening economic backdrop.
"Equity strategies that are focused on companies with dividend growth characteristics, yields above Treasuries with low payout ratios, that are less sensitive to rising recession possibilities and have strong balance sheets and management teams are still highly appropriate investments, even in this uncertain economic environment," he said.
Wall Street won't have to wait to find out whether the economy is recovering and which way the market will move.
Friday's nonfarms jobs report will provide significant clues about the direction, with consensus expecting an increase of about 80,000 but some economists worrying the economy may have lost jobs in August. The Fed then follows with its meeting on Sept. 20-21.
"Where we're going is going to be determined by data off Main Street," said Jim Paulsen, chief market strategist at Wells Capital Management in Minneapolis. "It's going to be what the weekly (jobless) claims numbers do, what jobs do, what retail numbers do. We're going to decide whether we're recessing or not. If we decide we're not recessing, I think we've back in the old (trading) range."
A consistent optimist about the market and economy, Paulsen thinks consensus projections of 1400 or better on the S&P 500—a leap of at least 14 percent from current levels—is still in reach.
That would mean, then, that this is a golden buying opportunity after a brutal summer. US equity mutual funds, after all, have shed about $36 billion in assets in the past three weeks, according to TrimTabs, indicating that the selling may be getting overdone.
"What investors should do is take advantage of the values that exist here today, moving from save havens to cyclicals," Paulsen said. "I'm looking to take advantage of the panic. That means letting people have some of the stuff they're so antsy to have, and taking some of the stuff they're throwing out the window."