Volatility Makes an Ugly Comeback

September lived up to its historical reputation for being a volatile and stressful month for equity performance.  The S&P 500 finished the month down 4.8% marking its worst month since November 2020 and the index closed over 5% below its record high for the first time this year.  For the month of September, the technology heavy NASDAQ fell 5.3%, while the Dow Jones Industrial Average dropped 4.3%.

This recent selloff “feels” particularly painful for investors because September snapped a seven-month winning streak.   This said, the S&P is still about 13% higher than where we started the year.  After the S&P 500 rallied over 100% from the COVID-19 lows in 2020, there could be many reasons for the selloff, but it could also simply be time for a well-deserved break.

All three indices have now broken near-term uptrend lines going back since Spring 2021 which has caused daily and weekly momentum gauges to turn negative.  Technical trends and momentum are currently bearish, and breadth has been falling sharply.  As stressful as this selloff has been, some additional downside is possible before the markets stabilize and resume their uptrend.   We believe more evidence of capitulation may be necessary in this highly tentative environment.

The good news is that a turning point may be nearing.  October has a reputation for violent selloffs but is typically a positive month.  Whereas September has historically been the worst month of the year for the stock market, October actually begins what is the best three-month stretch on the calendar.  Over the past 10- and 20-years October is the 4th best month, and it ranks 7th since 1950.  It turns out October is not the strongest month, but by no means the worst.

For the balance of the year, the historical perspective is encouraging.  In fact, the S&P 500 Index has been up 78.9% of the time in the fourth quarter, and by 4.0% on average, going back to 1950.  This represents the best readings out of all four quarters.  In those years where the S&P 500 is up solidly heading into the fourth quarter, the gains tend to continue through year-end (Bespoke).

To be certain, Wall Street will have to “climb a wall of worry” if it is to reverse course.  The markets are contending with several negative factors including uncertain fiscal and monetary policy, persistent inflationary pressures, global supply chain issues, China regulations/Evergrande solvency, along with Washington’s debt ceiling drama.

On the positive side, COVID-19 is impressively improving overall in the U.S. and daily cases could slip under 100,000 per day early in October.  The manufacturing sector and durable goods orders rose at a healthy clip in August, beating expectations and at a faster pace than expected.  Retail sales were quite strong in August, surprising the consensus.  Overall retail sales are up a robust 15.1% from a year ago and are up 17.7% versus February 2020, which was pre-COVID (First Trust).

Importantly, this level of economic activity will continue to translate into record corporate profits and forward expectations are still robust.  During the third quarter, analysts increased earnings estimates for companies in the S&P 500 by 2.9% marking the fifth straight quarter of rising expectations.  This is notable as in a typical quarter analysts usually reduce earnings estimates.  

During the past five years, the average decline in the bottom-up earnings estimate has been 2.9%. During the past ten years, the average decline has been 3.7% and over the past 15 years, the average decline has been 4.9%.

The third quarter will also mark the fifth-straight quarter in which more S&P 500 companies issued positive earnings guidance than negative guidance.  Expected earnings for the S&P 500 for the third quarter are higher today compared to the start of the quarter. The index is now expected to report the third highest (year-over-year) growth in earnings since the third quarter of 2010 (FactSet).

As corporate earnings are a key driver of equity prices, we do not believe the current bull market is giving way to a bear market.  Across the country we continue to see aggressive hiring trends amid a tight labor market and U.S. businesses are clearly signaling continued strength in profitability.  Accordingly, we believe strong above trend economic activity will extend well into 2022 and investors should remain constructive in their outlook and investment posture. 

Equity market selloffs will always be unsettling, especially following extended periods of progress.  They are, however, a normal part of how markets function.  As has been said many times, volatility is the price equity investors must pay for above average long-term returns.

We will continue to monitor and evaluate the many challenges that come our way.  You have our pledge that when the facts change, our perspectives will also change.  At the moment, our view is that, overall, the positive forces outweigh the negative and we continue to expect higher equity prices over the balance of 2021 and into 2022.

Thank you for your continued confidence in Clearwater Capital Partners.  Please do not hesitate to reach out to us should you have any concerns or should you wish to discuss our strategies in greater detail.

John E. Chapman - October 2021