Brace for the September Slide: Navigating the Market's Most Volatile Month

Markets took a significant hit on the first trading day of September, with the S&P 500 dropping over 2% and the Nasdaq plunging 3.1%, marking its steepest decline since July. The last 13 instances where the first day of the month saw a decline of 2% or more resulted in gains for the remainder of the month. However, it's worth noting that the two worst performances for the rest of the month also occurred in September—down 9.9% in 1974 and 7.1% in 2002. 

This widespread, aggressive selling has reignited discussions about the September effect and its potential impact on equity markets. In this article, we explore the September effect and how it might influence market behavior. We delve into key upcoming news events, including the Federal Reserve's decision and the upcoming elections, and how these factors could shape or alter the usual seasonal patterns. Additionally, we'll identify some investment opportunities that might perform well in this challenging environment.

As September unfolds, the market faces a series of potential risks that could significantly impact the S&P 500, which has already seen declines in each of the last four Septembers. The upcoming non-farm payrolls report may be particularly influential, with the market's reliance on a few mega-cap tech stocks heightening vulnerability to sharp drawdowns. Additionally, the first TV debate between Vice President Kamala Harris and former President Donald Trump could inject further volatility as the election season intensifies. The specter of a contested election, reminiscent of the 2000 scenario, adds another layer of uncertainty. While the Federal Reserve's anticipated rate cut is no longer in question, the magnitude of the cut remains a critical unknown. In this high-stakes environment, strategists emphasize the importance of caution in navigating the markets.

What is the September Effect?

The September Effect refers to the historically weak stock market returns observed during the month of September, making it the worst-performing month on average over the past century. This phenomenon is considered a market anomaly because it lacks a clear causal link or event, challenging the efficient markets hypothesis (EMH). While there is some statistical evidence to support the September Effect, much of the theory remains anecdotal, with recent years even showing positive median returns for the month.

One reason September tends to be volatile is that investors often return from summer vacations ready to lock in gains or realize tax losses before the end of the year. Additionally, individual investors may liquidate stocks to cover schooling costs, while institutional investors might sell assets as the third trading quarter comes to a close. This behavior can create a self-fulfilling prophecy, where market psychology turns negative in anticipation of the September Effect, further contributing to market volatility.

Despite these patterns, the September Effect is largely dismissed by economists as irrelevant in the modern market. They argue that even if it once existed, knowledgeable traders have since adapted their strategies to mitigate its impact. In fact, the frequency of large declines in September has decreased significantly since the 1990s, possibly due to pre-positioning by investors who now sell more in August to avoid the September downturn.

The increase in trading volume in September, as people return to their desks after the summer, also contributes to heightened volatility. September typically sees the second-highest trading volume of the year, following a relatively quiet July and August. This increase in activity can lead to more significant market movements, especially as investors reassess their portfolios after the summer's strong gains and look to reposition themselves for the remainder of the year.

Economists may be dismissive but...

September has long held the title of the worst-performing month for the stock market, with the S&P 500 averaging a monthly decline of 1.2% and finishing higher only 44.3% of the time since 1928, according to Dow Jones Market Data. This trend extends across other major indexes as well, with the Dow Jones Industrial Average ($DJIA(DJIA)) and the Nasdaq Composite ($QQQ(QQQ)) also typically experiencing lackluster performance in September, recording average monthly drops of 1.1% and 0.9%, respectively. The DJIA, in particular, has shown a consistent struggle in September, posting positive returns only 41.7% of the time since its inception in 1896.

The recent history of September has been especially challenging for investors. Over the past four years, the S&P 500 ($SPY(SPY)) has recorded significant declines each September, with drops of approximately 5% in 2023, 9% in 2022, 5% in 2021, and 4% in 2020. This consistent pattern of negative returns highlights the month's reputation as a tough period for stocks, reinforcing its status as the only month where the S&P 500 has consistently finished lower in each of the last four years.

The broader historical context further underscores September's difficult nature for investors. Since 1950, the S&P 500 has delivered an average return of -0.7% in September, making it the worst month for stocks based on average return and positivity rate. This pattern is significant from a statistical perspective, as the spread between September's average performance and that of other months is a notable 1.9 percentage points. Given this history, it's no surprise that September remains a month of heightened caution for market participants.

How was August?

It is helpful to understand how August unfolded so we can have a better understanding of the market dynamics heading into September. 

The U.S. stock market managed to close out a turbulent August on a positive note, recovering from significant losses earlier in the month, particularly on August 5, which marked Wall Street's worst day in nearly two years. Despite the volatility, the S&P 500 finished the month with a gain of 2.3%, the Dow added 1.8%, and the Nasdaq rose by 0.7%, according to FactSet data. However, with September historically known for its seasonal weakness, there is concern that this momentum could be disrupted by increased market volatility.

The performance of the so-called Magnificent 7 megacap tech stocks was mixed in August. Meta led the group with a substantial gain of 9.8%, followed by Apple, which was up 3.1%, and Nvidia, which edged higher by 2.0%. However, other key players in the group struggled, with Microsoft slipping 0.3%, Alphabet declining 4.5%, and Amazon dropping 4.6%. In contrast, several other sectors outperformed, with Financials ($XLF(XLF)) and Technology ($XLK(XLK)) leading the way, gaining 5.46% and 5.33% respectively, while Communication Services ($XLC(XLC)) lagged, down 0.70% for the month.

Positives Supporting the Market

As September begins, the market is buoyed by a series of positive factors that outweigh traditional seasonal concerns. One of the most encouraging signs is the broadening trend in market participation. Unlike earlier in the year when the market's gains were heavily concentrated in a handful of megacap tech stocks, August saw a much wider array of stocks contributing to the market's upward momentum. 

In fact, two-thirds of the S&P 500 posted gains in August, and the NYSE advance/decline line reached an all-time high. Additionally, more than 70% of NYSE-listed stocks are now trading above their 200-day moving average, indicating strong overall market health. The Equal-Weight S&P 500, which gives an equal allocation to all stocks in the index, modestly outperformed the S&P 500 in August and closed the month at a historic high, further highlighting the broadening of the rally.

This broadening trend is particularly notable when compared to the performance of the Magnificent 7 megacap tech stocks, which dominated the market earlier this year. While these tech giants did not perform poorly in August—Meta, for example, saw a nearly 10% gain—they were not the primary drivers of market strength. Since early July, the collective performance of the Magnificent 7 is down 10.2%, while the other 493 stocks in the S&P 500 have gained 4.1%. This shift suggests that the market is becoming less reliant on a few high-profile names and more balanced, which could be a healthier sign for the long-term stability of the market.

Earnings reports also continue to be a strong point as we head toward the third quarter. The second quarter saw S&P 500 earnings grow by an impressive 13%, and while third-quarter estimates are slightly lower at 5.7%, they still reflect solid growth. Looking ahead, earnings are expected to rebound strongly in the fourth quarter with a projected increase of 13.5%, and this momentum is anticipated to carry into 2025 with a 15% rise. The consistency in these earnings forecasts over the past several months underscores the market's resilience and provides a solid foundation as we prepare for the next earnings season.

Sentiment is another factor working in the market's favor. While bullish sentiment among AAII individual investors has risen to 51.2%, above the long-term average of 37.5%, it has not reached extreme levels that might suggest overexuberance. Bearish sentiment remains close to its historical average, indicating a healthy balance between optimism and caution. This moderate sentiment, combined with waning inflation—highlighted by the July Core PCE dropping to 2.5%—suggests that the market is on solid footing as it navigates the challenges and opportunities that September may bring.

The Upcoming Fed Decision

As September begins, all eyes are on the upcoming Federal Reserve meeting on September 17-18, where the central bank may kick off its long-awaited interest rate-cutting cycle. The recent PCE inflation data suggests that the Fed is on track to cut rates, with market participants expecting a series of three 25-basis-point reductions this year. However, the upcoming August employment data, especially the nonfarm payrolls report, could significantly influence the Fed's decision. If the labor market shows signs of further slowing, it might prompt the Fed to consider a more aggressive 50-basis-point cut, although such a move could also signal deeper economic concerns, leading to heightened market volatility.

Market performance following rate cuts has historically been mixed. Over the past nine major rate-cutting cycles since the 1970s, the S&P 500 has delivered modest returns in the three months following the first cut, with average 12-month returns of around 5.5%. However, these periods have also seen substantial drawdowns, with maximum declines of 19-20%, larger than the average drawdowns in other years. This historical context suggests that while the initial rate cut may not immediately drive significant stock gains, the broader economic trajectory, including whether the U.S. can avoid a recession, will play a critical role in determining market performance in the coming months.

The importance of the upcoming jobs report cannot be overstated. Scheduled for release on September 6, the nonfarm payrolls data will provide crucial insights into the health of the U.S. labor market. With the Fed closely monitoring employment figures as part of its decision-making process, this report could set the tone for the rest of the year. Analysts expect the data to show a cooling job market, which aligns with the narrative of a slowing economy. However, any surprises in the report could lead to significant market reactions, especially with four rate cuts already priced in by year-end.

The market would like to see a rate cut as it views the current levels as being too restrictive. However, there has been an underlying concern that the rate cuts will be driven by recession fears rather than the idea that the central bank needs to 'tweak' policy. The market already has dealt with a poor July jobs number as well as a massive revision of 818,000 jobs for the period from March 2023 through March 2024. Another negative data point would raise recession concerns which would offset some of the goodwill of a rate cut. 

The Election Year Caveat

The upcoming U.S. presidential election is poised to add a significant layer of uncertainty and potential volatility to the stock market. Historically, election years have been associated with heightened market fluctuations as investors react to the shifting political landscape. This year is no exception, with concerns that the results of the November 5th election may not be immediately clear, prolonging market uncertainty during what is typically a seasonally strong period for stocks. The possibility of a contested or delayed outcome adds another dimension of risk, which could exacerbate market volatility in the weeks surrounding the election.

However, there's a silver lining when it comes to election years and their impact on the notorious September effect. While September is often regarded as the cruelest month for the U.S. stock market, this trend tends to soften during presidential election years. Historical data shows that the Dow Jones Industrial Average has, on average, managed a modest gain of 0.2% in September during election years. This performance is statistically on par with the average returns seen in other months of the year, offering a glimmer of hope for investors wary of the typical September downturn.

Moreover, the idea that Septembers in election years are less harsh suggests that investors might reconsider the usual strategy of moving to cash during this period. The stability seen in past election years may encourage market participants to remain invested, especially if they focus on sectors and industries that have historically performed well in September, even as the broader market has struggled. This nuanced view of September's market behavior during election years could provide a more balanced approach to navigating the upcoming volatility.

Hedging Against the September Effect

Hedging against the typical September market volatility may not be necessary or cost-effective this year, given the current market conditions. Despite September's reputation for market turbulence, the Cboe Volatility Index (VIX), often referred to as Wall Street's fear gauge, has seen a significant decline, dropping 77% since its early August peak. As the VIX remains well below its long-term average, there is no imminent worry that justifies the expense of hedging at this time.

However, the managers caution that they are closely monitoring the VIX for any signs of a surge, which could signal the need to start hedging. They acknowledge that several upcoming events in September could potentially increase market volatility, but for now, their strategy is to watch and wait. This approach underscores the importance of the VIX as an indicator for timing hedging activities, ensuring that protection is only put in place when necessary to avoid unnecessary costs.

Well, today we saw that surge in the VIX as it rallied back above the 20 level. Perhaps even more interesting is the recent massive call activity we saw in the VIX September 18 calls from the CBOE last Friday:

Obviously some big pockets wanted to have some protection against the downside on Fed Day. This certainly had an impact on the markets.

Is there Anywhere Safe to hide?

As September's reputation for volatility looms, investors looking to stay in the market might consider shifting their portfolios toward sectors that have historically outperformed during this challenging month. According to data from Dartmouth College professor Ken French, certain industries have consistently delivered positive returns in September, even when the broader market struggled. The top five sectors with the best average September returns since 1963 include gold and precious metals with a 1.4% average gain, followed by insurance (0.7%), personal services (0.6%), oil (0.5%), and healthcare (0.5%). These sectors have shown resilience, significantly outperforming the Dow's average September return of minus-1.1%.

We would note that defensives did outperform on a relative basis in Tuesday's session. Staples (XLP) posted a gain of 0.7%. Utilities (XLU) and Healthcare (XLV) did wind up closing in the red but we would view that as potential margin calls as investors were forced to meet hefty losses in the semiconductor sector. Oil (XLE) companies did see selling pressure due to growth concerns. However, if we see better than feared jobs numbers this week then the pullback in the sector could provide some opportunities. 

Some of the criteria that this group meets include lower betas, indicating less volatility compared to the broader market, and attractive valuations. Furthermore, these stocks provide dividend yields that exceed the market average, adding an extra layer of protection against potential market downturns.

By focusing on these carefully selected sectors and stocks, investors can potentially mitigate some of September's risks while positioning themselves for better-than-average returns. The combination of historical outperformance, lower volatility, attractive valuations, and higher dividend yields makes these sectors and stocks compelling options for navigating the typically turbulent September market.

Conclusion

Today's session has raised concerns as the market kicked off September with significant declines, reigniting fears of the September effect. While there is strong historical evidence supporting the idea that September tends to be a challenging month for the stock market, this pattern isn't set in stone, and exceptions do exist. The upcoming Federal Reserve decision, the release of the non-farm payrolls report, and the looming presidential election all have the potential to influence how this September unfolds, either reinforcing or unwinding the typical seasonal trends. Investors should remain vigilant as these events could introduce unexpected volatility.

Despite the potential for a rocky September, there are still opportunities for investors. Sectors that have historically outperformed during this month, such as gold and precious metals, insurance, and healthcare, may offer some protection against broader market downturns. Additionally, with the VIX—a key measure of market volatility—recently spiking, there may be a case for cautious hedging, though portfolio managers advise waiting for clearer signals before taking action. Ultimately, while September's reputation may cause concern, a well-considered strategy focusing on resilient sectors could help navigate the challenges ahead.