Sun Is About to Set on Summer’s Rally

by Dan Burrows | August 21, 2012 1:09 pm

If you’ve been fortunate enough to enjoy the remarkably quiet summer rally in stocks, it might be time to protect some hard-won gains.

After all, stocks have come very far, very fast; corporate earnings and revenues don’t support much more upside; and there’s ample reason to expect a pullback soon enough.

Oh, and September is historically the worst month for equities by a long shot.

The relentless if incremental rally of August has the market sitting at a level not seen since 2008. The S&P 500 has quietly added 4.5% this month with nary a hiccup (never a good sign), giving it a gain of more than 13% for the year-to-date.

Heck, since June 1, stocks have risen almost 12%.

Optimism that Europe will contain its debt crisis and some better readings on the U.S. economy are getting all the credit for the run-up in equity prices, but it may just be a case of traders buying the rumor.

Which means they’ll be selling the news soon enough.

We’ve seen a version of this pattern twice before, except this time the tail is wagging the dog. Over the last two years, the economy hit a soft patch, the Federal Reserve and its European counterparts announced policy actions, and the market subsequently rallied.

But this time around it’s different. The Fed and the ECB are expected to announce major policy moves in September, aimed at shoring up the U.S. recovery and stabilizing the euro. The market is taking these actions as a given — and that’s why a retreat is likely.

“Unlike 2010 and 2011, this year the stock and bond markets are leading the policy actions,” writes Jeffrey Kleintop, chief market strategist at LPL Financial (NASDAQ:LPLA[1]). “This sets up for a departure from the pattern of the past two years, since the rebound in stocks relative to bonds on the announcement of QE3 and European policy actions appears to have already largely taken place.”

Since we’re very likely to get the policy actions that the market is anticipating — and the rally has taken place on exceedingly light volume and zero volatility — a pullback is in the cards. “With market participants having bought the rumor surrounding policy actions this year, they are unlikely to buy again on the news when the policy actions emerge,” Kleintop says.

He doesn’t expect a major sell-off, but he does foresee a return of volatility, which makes a lot of sense. Stocks never move in a straight line — at least not for long — but that’s essentially what they’ve done in August.

In June and July, the S&P 500 experienced four retreats of 2% to 4%. Then the doldrums hit. The market’s average absolute daily percentage changes so far this month have only been this narrow once before in history, and that was back in 1996.

It’s just too quiet out there.

And, unlike the past two autumns, we have the U.S. presidential election and the pending “fiscal cliff” adding to the uncertainty, Kleintop notes.

There are plenty of other risks to worry about. Nomura (NYSE:NMR[2]) strategist Bob Janjuah expects the Fed and the ECB to disappoint markets with both their words and their deeds. Ed Yardeni, president of Yardeni Research, says it’s hard to see much more upside in the S&P 500 with earnings and revenue growth stalling out[3].

Furthermore, Chinese equities aren’t participating in the rally[4], we’re not getting confirmation from small-caps or transportation stocks, and this bull market, now three-and-a-half years old, is getting a bit long in the tooth.

Finally, there’s the curse of seasonality. Whatever the reason, September is the cruelest month for stocks. Since 1950, the S&P 500 has posted an average decline of about 0.6%, according to Citigroup (NYSE:C[5]) strategist Tobias Levkovich.

Given those risks, it might be time to allocate away from the hot cyclical sectors like tech, financials and consumer discretionary, and try to pick up more defensive areas on the cheap.

One scary headline could cause the risk-off trade to come back with vengeance[6].

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

  1. LPLA:
  2. NMR:
  3. earnings and revenue growth stalling out:
  4. Chinese equities aren’t participating in the rally:
  5. C:
  6. risk-off trade to come back with vengeance:

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