KEY TAKEAWAYS
· We continue to expect an improving economic backdrop in the second half and a stock market with the potential for more new highs before year-end.
· However, growing near-term concerns are making the odds of some type of a late summer correction more likely.
The S&P 500 gained 3.6% during the historically bullish month of July 2016, closing higher for the fifth consecutive month for the first time in two years. It also soared to new all-time highs for the first time since May 21, 2015. As discussed in our Weekly Market Commentary, “Overcoming a Wall of Worries” (June 20, 2016), the list of worries had been long, but we thought an improving economic backdrop coupled with strong market breadth and a very pessimistic sentiment backdrop should help the market resolve higher, which fortunately happened.
Now the big question is, can this strength continue and the S&P 500 close higher in August to make it six straight months of gains? Although we continue to expect an improving economic backdrop in the second half of the year and a stock market with the potential to make more new highs before the year is over, there are some growing near-term concerns — making the odds of some type of a late summer correction more likely. The good news is we do think this weakness will be an opportunity to add to equity exposure and higher prices could still come later this year.
Here are four growing concerns:
#1: SEASONALITY
The good news is July seasonality (on average the strongest summer month) worked perfectly this year. The bad news is after the S&P 500 gains more than 3% in July (like it did in 2016), August has been lower four of five times going back 20 years, with an average decline of 2.3%. Also, as we mentioned on the LPL Research blog last week, the S&P 500 is in one of the its tightest ranges ever. In fact, using daily closing prices it was recently in the tightest 11-day range since August 1995. In other words, the odds that this tight range changes into rising volatility are very high this August.
More bad news is that August and September are historically two of the weakest months of the year for the S&P 500. Going back to 1980, they are the only two months to have a negative average return [Figure 1]. Looking specifically at August, on a price return basis it returns -4.8% on average when it is negative, the largest drop for any month of the year. In other words, when August is down, it is really down. For example, it lost 6.3% last year on the surprise China yuan devaluation, lost 5.7% in 2011 on the U.S. debt downgrade, 14.6% in 1998 thanks to the Russian financial crisis, and 9.4% in 1990 after Iraq invaded Kuwait.
Why do these unknown events seem to take place in August? It could be simply random, or maybe the effects of big news is amplified in the summer when trading is light and many are taking summer vacations. This doesn’t mean we will have another unforeseen market shock this month (we would tell you if we knew!), but be aware it wouldn’t be out of the question either.