August is living up to its reputation as a lousy market month, but no one's panicking

Published Mon, Aug 21 20238:04 AM EDTUpdated Mon, Aug 21 202310:38 AM EDT

As we enter its final two weeks, August is living up to its reputation as a lousy month. Three straight down weeks. With a decline of 4.8%, this is the worst month so far for the S & P 500 since December. With the exception of energy and health care, which are basically flat for the month, the pain is fairly evenly distributed: S & P sectors in August Technology down 7.8% Banks down 7.2% Utilities down 5.8% Materials down 5.8% Consumer discretionary down 5.8% Real estate down 5.2% Communication services down 5.2% Industrials down 4% A 5% drop in the S & P 500 in August has been painful to watch, but it has made the market far more reasonable to own. As we entered August, the S & P 500 was approaching a valuation of 20 times forward earnings. That is one of the richest multiples in many years (the historic average is 17), and a warning sign, since the forward multiple does not normally stay above 20 for long. By Friday's close, it was 18.8. Not only was the multiple down, but forward earnings also have not budged. Now the bad news: Treasurys are really giving stocks a run for their money Unfortunately, even with lower prices in August, stocks are still not very compelling, due to rising Treasury yields . We've spent a lot of time talking about the high multiple (P/E ratio) for the S & P 500. Another way to look at the problem is the equity risk premium. The equity risk premium is the excess return that investing in the stock market provides over a risk-free return (usually assumed to be 10-year Treasurys). This return is supposed to compensate investors for assuming the additional risk that owning stocks entails. Right now, it is below 1% and heading toward zero. The ERP is usually calculated using a shorthand method: S & P 500 earnings yield (the inverse of the P/E ratio) minus the 10-year Treasury yield. Using this calculation, the current earnings yield of 5.3% for the S & P 500 minus 4.2% for the 10-year Treasury gives an ERP of 0.9%. Is that good or bad? It's bad. Since the Great Financial Crisis, the ERP has typically been between 2% and 4%. Below 1% and we are near the worst levels since 2007. Simply put, it means there is very little reward for the extra risk investors are taking for owning stocks. Back to the good news The good news is, volumes remain seasonally light. This means the decline in prices is due to a lack of buyer enthusiasm, not a mad dash for the exits. The Cboe Volatility Index , which is an expectation of volatility for the next 30 days, remains at 17, well below the historic norm of about 20. That means no panic. Moreover, the VIX futures curve is in a near-perfect contango, meaning futures contracts several months out are slightly higher (in the 19-20 range) than the next 30 days, which is as it should be: the future three months to six months out is much more unknowable than the future a mere 30 days away. All of this is a shorthand way of saying this is still a garden-variety correction: "The market's data remains more in line with a pause than a new downtrend," technical analysis service Lowry said in a note to clients over the weekend. The problem for stocks is that we are in a news vacuum. We need more information to confirm inflation is moving down (the big hope is that home prices will start coming down soon), but we're not going to get it for a few weeks: Personal consumption expenditures prices for July are not out until Aug. 31. With real (inflation-adjusted) Treasury yields rising, the market is now fearful that Fed Chairman Jerome Powell will again sound uber-hawkish at the Jackson Hole event on Friday. This is a real flip in sentiment from a few weeks ago, when the hope was he would assume a much more dovish posture.