‘Sentiment changed so quickly’: Why stock market lows may be revisited as S&P 500 enters weakest stretch of year

As summer draws to a close, the US stock market is in a potentially volatile decline.

“Recession fears are the most likely trigger for a retest of the June lows,” Ed Clissold, chief U.S. strategist at Ned Davis Research, said in an Aug. 31 note. “From a seasonality perspective, a retest could come in the coming weeks.”

When U.S. investors return from the long Labor Day weekend, history suggests they will face the weakest period of the year for the S&P 500: the stretch from Sept. 6 to Oct. 25, according to the note.

NED DAVIS RESEARCH REPORT DATED AUG. 31, 2022

The stock market is already shaken.

US stocks closed sharply lower on Friday, with the three major benchmarks suffering losses for a third week in a row. However, the S&P 500 SPX,
-1.07%
closed 7% above a 52-week low of 3666.77 on June 16, according to Dow Jones market data.

“I think we have to go back and test that level,” Bob Doll, chief investment officer at Crossmark Global Investments, said in a telephone interview. “I don’t think the bear market is necessarily over,” he said, although “what I don’t see is a huge drop from here.”

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Meanwhile, continued interest rate hikes by the Federal Reserve to combat rising inflation in a slowing US economy raise the odds of a recession along with the outlook for this year’s stock market lows to be reassessed, according to a note by Ned Davis. The Fed this year is “committed to removing liquidity from the financial system,” making a review more likely, Clissold wrote.

Vanguard Group said in a report on Sept. 1 that it had downgraded its forecast for U.S. economic growth this year after two straight quarters of contraction. The company now expects economic growth of 0.25%-0.75% for the full year 2022, down from its estimate last month of around 1.5%.

“We believe it is likely that the United States will struggle to recover above-trend growth in the coming quarters,” Vanguard said. “We place the probability of a US recession at around 25% over the next 12 months and 65% over the next 24 months.”

Whether any “retest” of stock market lows is short-lived may depend on the US’s ability to avoid recession, according to Ned Davis.

“The average rise without a recession lasts about seven months and has fallen 25% (-18% over the past half-century), placing the January-June decline with the typical case,” Clissold wrote in the Ned Davis note. “In contrast, the average recession lasted about a year (17 months over the last 50 years) and fell by an average of 35%.

“dragon” of inflation

Investors expected another big rate hike from the Fed at its Sept. 20-21 meeting after Chairman Jerome Powell sent a clear message in his Jackson Hole speech on Aug. 26 that the central bank would continue to fight high inflation until the job is done – even if it means some pain for households and businesses.

Stocks fell on his remarks that day, with the Dow Jones Industrial Average DJIA,
-1.07%
closing 1,000 points and losses have deepened since then.

The “strong” rally in stocks seen earlier in the summer reflected “excessive optimism given that we are still in the early stages of fighting inflation,” Crossmark’s Doll said. While he believes inflation has peaked, Doll predicts that its continued decline this year will likely be bumpy and end in 2022 above the Fed’s 2% target.

“It’s not going to come down to a level where we’re like, ‘okay, we’ve got this dragon, what’s next?’ he said. If inflation, which reached 9.1% in June based on the consumer price index, eases to 4% or 5%, “that’s good news, but not good enough news to say the Fed is done” , Doll said.

Vanguard expects the Fed to raise its federal funds target to a range of 3.25%-3.75% by the end of the year, from near zero in early 2022, according to its note. This compares to a current range of 2.25% to 2.5%.

Before Powell’s speech in Jackson Hole, the market narrative had shifted from the Fed fighting inflation through aggressive rate hikes to “when will they turn around?” said Steve Sosnick, chief strategist at Interactive Brokers. But using a relatively short speech that had “no ambiguity,” Powell shifted the focus to monetary tightening and the Fed’s unfinished fight with inflation, sending “a very strong message to the market,” Sosnick said.

“We’ve been dealing with this ever since,” he said, pointing to stock market losses.

“The fact that we’ve moved so quickly and the psychology has changed so quickly makes me think we’re nowhere close to seeing the last of the volatility, particularly in the fall,” Sosnick said. “The September-October period certainly has more than its fair share of market weirdness.”

Stock market down?

Equity and quant analysts at Bank of America said in a note dated September 2nd at BofA Global Research that valuations for the S&P 500 remain “rich.” In their view, “the bottom is not in.”

“Initially, the rally from the June lows looked more like a young cyclical bull than a bear market rally,” Clissold said in the Ned Davis note. “Several push-widths and widening new highs suggest that much of the decline had progressed.”

However, the mid- and long-term range needs to be followed to confirm a bullish market, he said, and without that confirmation, “a retest cannot be ruled out.”

“The S&P 500 settled just below its bearish 200-day moving average and has given up about half of its gains from June 16 to August 16,” Clissold wrote. Also, “the percentage of stocks above their 50-day moving averages just missed the 90% mark.

U.S. stocks ended Friday with weekly losses, with the S&P 500 SPX,
-1.07%
down 3.3% while the Dow Jones Industrial Average DJIA,
-1.07%
and the tech-heavy Nasdaq Composite COMP fell 3%,
-1.31%
fell 4.2%.

The US stock market will take a break on Monday to celebrate Labor Day, resuming trading on Tuesday. Next week’s economic calendar includes data on US services, jobless claims and consumer confidence, as well as the release of the Fed’s ‘beige book’, which includes a collection of business anecdotes from around the country.

Continued aggressive rate hikes by the Fed combined with weakness in corporate earnings and the labor market “is not a strong backdrop for buying stocks,” Liz Ann Sonders, chief investment strategist at Charles Schwab, said by phone. Also, “we know September, seasonally, tends to be a weak month” for stocks.

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