There are growing signs a market correction is coming, and September is often a common time for one

Published Thu, Aug 19 20219:52 AM EDTUpdated Thu, Aug 19 202110:28 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

After a summer of rapid fire new market highs, some strategists see growing signs a stock market correction is coming, and September has historically been a common time for one. Stocks have already been jolted this week, as concerns about the Federal Reserve's move to cut back on its bond purchases rattled investors. Stocks slid again Thursday morning , after the S & P 500 fell 1.1% Wednesday for its worst performance since July 19. The S & P 500 is down more than 1% for the week, and off by nearly 2% from its record. Strategists point to concerns about inflation, the Covid-19 delta variant, the Fed's plan to taper bond purchases, a consumer slowdown and, most recently, geopolitical risks in the aftermath of the the pullout of U.S. troops form Afghanistan. The calendar will also soon roll over to September, which is historically the worst month of the year for the stock market. It is also a time when many strategists say it would be better to shift into value and cyclicals over growth and large-cap tech. "What poses risk for the market is that sentiment levels are high, valuations are high and it's been on a tear of late," Richard Bernstein Advisors deputy chief investment officer Dan Suzuki said. "And at the same time, there are a lot of potential catalysts that could get the market worried. "If you just think about over the last week or so, we've gotten a worsening narrative on pretty much all fronts, whether you're looking at the geopolitical tensions due to Afghanistan, you're looking at the Covid infection rates, or the rate of growth in the U.S.," Suzuki added. "Everything has been incrementally negative." Given how expensive the market has become, Suzuki said it is easy to see a 10% correction, but he's not expecting a major sell-off. Melt down or melt up? BTIG head of equities and derivatives strategy Julian Emanuel said his base case is for a correction down to about 4,000 on the S & P 500. The S & P 500 closed at 4,400 on Wednesday, off its latest high of 4,480. He also thinks the volatility this week could be foreshadowing a bigger market event. "We think the Fed is very data dependent at this point," he said. "Putting it all together what you have to ask yourself is there more or less uncertainty than a week ago?" He said last week's surprising drop in consumer sentiment to the lowest level since 2011 was a warning, and data this week has disappointed, including retail sales which declined 1.1%. "Clearly, between the Fed dialogue, the delta variant and the plunge in consumer sentiment, there is more uncertainty in an environment where traditional seasonality becomes a headwind in August, leading into September, which is the weakest month, and then presumptively into a tradeable October low," Emanuel said. Emanuel said the risks are increasing ahead of a normally more volatile time of year, and the Fed is preparing to take its first steps away from the easing policies it used to fight the impact of the pandemic. The Fed's purchases of $120 billion a month in Treasury and mortgage securities was intended to add liquidity to markets and help keep rates low. Once the Fed starts to pare back those purchases, it would be on the path towards ultimately raise interest rates. The Fed's easy policies have been credited with driving stocks to highs. "A correction is expected, but if we're wrong in our view we could be really wrong," Emanuel said. What could happen is the market's increasing wall of worry could be met by a "wall of money" that had been flooding into commodities and bonds this year. "If we're wrong, we're not going to be just slightly wrong, we're going to be really wrong," he said. "Above 4,500 (on the S & P 500), we just think the market could take on characteristics reminiscent of late 1999 - an epic emotional chase that completely disregards any of the risks that in our minds are intensifying." If the market surges instead of stalls and sells off, he said that rally could be fierce and short-lived. September is the worst But the odds are against that surge in September, based on history. CFRA chief investment strategist Sam Stovall has been expecting a correction, and he says September has historically been the time for one. Since World War II, he notes the S & P 500 has been down 0.56% on average in the month, and has been negative 55% of the time. The S & P 500 is up an average of 0.7% for all months since World War II. February is the only other month besides September, averaging a decline in that period. The decline is even worse in September if it's the first year of a new president's term, with an average drop of 0.73% in those years. For the Nasdaq, the performance was also worse during a president's first year in office. On average, it lost 1.29% in those years, versus an average September decline of 0.43%. For years when the S & P 500 hit new highs in July and August, like this year, Stovall says the index averaged a 0.74% decline in September and was higher only 43% of the time. The S & P 500 hit seven new highs in July and eight in August so far. "Even though I am getting tired of hearing myself cry wolf, I do think we are getting closer and closer to a meaningful digestion of recent gains," Stovall said. "The S & P is 11% away from its 200-day moving average and it is 2% [as of Tuesday] above its 50-day moving average." The S & P 500 has bounced off its 50-day moving average repeatedly, as traders and technicians have locked on to that area as a level of support and one that brings in dip buyers. The 50-day, basically an average of the last 50 closing prices, was at 4,349. "I would say 5% is going to be a meaningful decline," Stovall said in an interview Wednesday. He added the S & P has not had a 5% decline in 278 days, and the average length of time for a 5% move lower has been 104 days. The S & P 500 is up 17.1% year to date. "Yes, there's a correction coming, and yes it will happen. What we don't know is when," Stovall said. "September is a window dressing month. It's an end of quarter month for many mutual funds, it's an end of year month. A lot of companies are going to say let's dump those dogs that I don't want to show anyone I still own." Value, cyclicals over growth, tech Emanuel and other strategists expect cyclicals to do better than value over growth and tech now. Emanuel says health care also makes sense if investors are worried about geopolitical uncertainty. He also said consumer staples would be attractive since they provide yield, and they can raise prices in an inflationary period. Suzuki said the large-cap growth is at the heart of what he sees as a bubble in part of the market, and investors should steer away from those stocks. He said there are a number of signs this bubble has been brewing. They include the amount of liquidity in markets, the amount of leverage used by investors, the amount of new issuance, and the democratization of markets, meaning the swell of new retail investors buying stocks. "Given the fundamental backdrop, I'm actually optimistic that the underlying fundamentals for the U.S. economy and the market are strong. That said a huge portion of the markets - a third to 50% - is near or at the epicenter of a bubble in the equity market," Suzuki said. When the tech bubble burst in 2000, he said small-cap value stocks were up 40% for the calendar years of 2000 and 2001. That compares to a 50% to 60% decline in tech in that time frame. "If the bubble is on one side of the seesaw, you want to get as far away from that side of the seesaw," Suzuki said. "If the bubble is U.S. large cap growth, you start to buy less U.S., less large caps and less growth." For that reason, he is looking at value and cyclicals and more stocks outside the U.S., including emerging markets excluding China.

A trader works on the floor of the New York Stock Exchange (NYSE), July 21, 2021.

Brendan McDermid | Reuters

After a summer of rapid fire new market highs, some strategists see growing signs a stock market correction is coming, and September has historically been a common time for one.