Stocks Have Had a Great Year. Cue the September Effect.

By Charley Grant Aug. 4, 2023 The Wall Street Journal

September is traditionally the weakest month for U.S. stocks. This year, investors say the turning of the calendar should be especially worrying.

Stocks have risen sharply after last year’s selloff, defying any number of risks along the way. The S&P 500 is up 17% so far this year, including a 3.1% increase in July that reflected gains across all 11 sectors. Wall Street’s so-called fear gauge, the Cboe Volatility Index, is sitting well below historical averages.

If history is any guide, investors’ optimism will soon be put to the test. The S&P 500 has lost an average of 1.1% in September dating back to 1928, making it the worst month for stocks’ performance. It isn’t just a few bad years dragging down returns: The broad index has risen less than 45% of the time over that period, also the worst month by that measure, according to Dow Jones Market Data.

There is no clear reason for what is known as the “September effect.” But it is typically a month without the type of news that can push stocks higher, such as major corporate earnings, said Jay Hatfield, chief executive officer of Infrastructure Capital Advisors.

“The basic theory is that good news almost always comes from the companies, and the bad news comes from random events.” Hatfield said. He pointed to Fitch’s recent downgrade of the U.S. credit rating as an example.

So far this year, investors have brushed off fears of high inflation, a significant decline in corporate earnings, a possible recession, a standoff over the U.S. debt ceiling and the largest bank failures since the global financial crisis.

But there are warning signs that this year’s rally could lose steam. Valuations are above their recent norms, with the S&P 500 trading at 19.4 times forward earnings estimates, according to FactSet. The one-year average is 17.7 times. Inflated valuations alone don’t cause stocks to drop, but they can make a decline more severe.

Meanwhile, the 10-year Treasury yield is at its highest level in nearly a year, making it less attractive to hold stocks instead of bonds. On the borrowing front, some fear the repercussions of the highest interest rates in 22 years have yet to take full effect in the economy. And many investors think the Federal Reserve will need to keep rates higher for longer, particularly with rising oil prices threatening to stoke inflation again.

“If we were to put the kibosh on the idea that the Fed is done, then we might have an issue,” said James Bianco, president of Bianco Research.

U.S. economic growth accelerated in the second quarter from the first three months of the year, raising hopes that the Fed would manage to pull off a soft landing. Yet some bears think it is too soon to say the risk of a recession has faded.

“We’ve just been through the most aggressive hiking cycle in my career. It’s a bit presumptuous to think we’ve felt all those effects,” said Rob Williams, chief investment strategist for Sage Advisory Services. He said that the outlook is better for bonds than for stocks. Within stocks, he prefers more-defensive sectors such as consumer staples that tend to perform steadily even in a sluggish economy.

So far in August, the S&P 500 is down 1.9%, compared with its average gain of 0.67% for the month. The information technology sector, this year’s best performer, is down about 3%.

The artificial-intelligence enthusiasm that has powered tech stocks higher could also sputter.

Chip maker Nvidia, whose shares have tripled this year, reports quarterly results on Aug. 23. The end of earnings season soon after could create a void of good news until the fall.

“Once Nvidia goes, then what’s your catalyst?” asked Hatfield of Infrastructure Capital Advisors. He said he expects stocks to pull back in September, then rally again in the fourth quarter.

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