IT couldn’t go on forever

The pause in the equity markets’ ascent over the past couple of days shouldn’t have come as much of a surprise to observers. Given equity valuations, especially within the technology sector, it was only a matter of time that we would see a pullback. We’ve yet to see whether this will turn into a full-blown correction; regardless, the ingredients are there. We highlight the three factors that may play into equity market returns over the next two months.

The information technology sector has been leading the market lower over the past couple of days. It shouldn’t be too much of a surprise as tech was one of the leading sectors since the bottom of the market on March 23 (consumer discretionary has been the other leader). In fact, it has been the traditional cyclical sectors that have been leading the way off the low — less energy, materials, industrials, consumer discretionary, and tech. We believe the market rally has been driven in part by monetary inflation from the U.S. Federal Reserve (the Fed), an economic recovery (modest, but a recovery nonetheless), and momentum (let’s call them “Robin Hood and its merry men”). Over the last number of weeks, it could be argued that it has been momentum as fundamentals have barely factored at all into the rally. There comes a point when the fundamentals have to matter again, and valuation has to come back to reasonable levels.

There has been a belief that valuations at higher than average levels are sustainable given the Fed’s commitment to low interest rates for the next couple of years. While we would agree, as interest rates and inflation trend lower, valuations can trend higher; however, there are limits. Overall, some of our valuation metrics would show that the S&P 500 Index is exhibiting overvalued levels. Based on the Rule of 20, the S&P 500 Index is currently sitting at 1987 levels. A valuation correction seemed inevitable.

Since 1950, September has recorded the worst monthly return for the S&P 500 Index, in terms of median and average return. Additionally, September is also the month with the highest occurrence of negative returns — losing money 52% of the time. If there’s going to be a month where we could expect higher volatility and a greater probability of a correction, September is it. It’s too early to say that this is a correction yet. However, September isn’t on the investor’s side.

But wait, there’s more! We’ve suggested that the next couple of months may be particularly precarious for investors as we have the U.S. election coming November. In presidential election years, October holds the worst monthly average return at -0.74% and the third-worst median return of 0.21%, while delivering a negative return 44% of the time since 1952.

Lastly, as we’ve written about, we’ve noted three stages to a bear market recovery. The exhaustion stage follows a peak in price-to earnings (P/E) multiples. If we’ve seen the peak in the P/E multiple for the S&P 500 Index, then we should expect market returns to be below average over the next couple of years. The current price action may be an indication that we’ve entered the exhaustion stage of this market.