Why the S&P's September Returns Are So Crucial

The next month could have long-term implications for the S&P 500 Index (SPX)

Senior Vice President of Research
Sep 8, 2015 at 9:16 AM
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"… [T]he significant long-term 20-month moving average is sitting around 1,990, with the SPX in this vicinity as we approach the end of the month today. It will be important for the SPX to close the month either above or very close to this trendline, or the risk increases that we could be looking at a lengthier sell-off that pushes the SPX more than 20% below this year's highs.

In addition to closes well below this moving average in 2000 and 2008 being followed by prolonged sell-offs, closes below this trendline in May 1977, September 1981, October 1987, and August 1990 preceded either: 1) Two to three months of additional weakness (October 1987 and August 1990); or 2) Longer-term declines over several months (May 1977 and September 1981)."

-- Monday Morning Outlook, August 31, 2015

With the S&P 500 Index's (SPX - 1,921.22) end-of-August close below its 20-month moving average, the bears have a little more ammo to make their case. As we noted last week, monthly closes below this trendline during the past 40-plus years have historically preceded additional short-term weakness before the ship rights itself, at best, amid increased odds of prolonged weakness.

That said, bounces -- or retests -- of the trendline have a tendency to occur, so one should not be surprised if the SPX finds itself retesting this trendline sometime over the course of the next few months.

If the August close simply means two to three months of additional weakness, one potential scenario is a repeat of 2011, in which the break of the 20-month moving average was followed by a decline to its 40-month moving average -- a trendline that has also proven to be historically significant during the past several years. This long-term moving average, per the chart below, is situated around 1,785, or 16% below the May closing high at 2,130. A pullback to this potential support area would not qualify as an official bear market, according to Wall Street's traditional definition of a move 20% lower or worse.  And for bulls, note the ferocious rally that occurred as the SPX lifted from this trendline beginning in October 2011.

150904mmoSPX

The table below summarizes the historical implications of the SPX experiencing a monthly close below its 20-month moving average, following at least 12 consecutive monthly closes above this trendline since 1970. 

150904mmoStats

The data shows:

  1. Slightly negative returns, on average, during the next one to two months, with a higher-than-usual probability of moving lower. In fact, the probability of the SPX finishing higher two months after a signal is slightly less than a coin flip.
  2. A lower-than-usual probability of the SPX being higher 12 months after the signal, amid higher standard deviation of returns and lower average returns. Specifically, the chances are still a little greater than a coin flip that the market closes higher the following year, but this is less than the typical 75% expectation when the SPX experiences monthly closes above this trendline.
  3. Three and six-month returns that are above average, with the probability of finishing higher matching what is usually expected. Therefore, the most likely scenario is weakness for the following two months.

To re-emphasize, bullet No. 2 would suggest heightened risk of a weak market 12 months out, but this is far from a slam-dunk. Because of the greater uncertainty and higher standard deviation of returns, it suggests less exposure to the market if you have a longer-term time frame. 

After diving into this data further, we found that how the following month plays out could be an indication of how the next 11 months play out. Specifically, when the SPX was flat to negative (up less than 0.49%) a month after the signal, its 12-month return was negative five out of seven times.  But if the SPX was higher by 1% or more one month after its first monthly close below the 20-month moving average, it was higher 12 months later in all four instances: all double-digit returns, three returns in excess of 20%. 

So, while risk is increased, this is not necessarily a signal to move 100% in cash. The higher-than-average volatility that is expected over the next 12 months could also produce higher-than-average returns, even as the probability of a higher market 12 months out is now lower than normal.  

"The nation's second-largest pension fund is considering a significant shift away from some stocks and bonds, one of the most aggressive moves yet by a major retirement system to protect itself against another downturn … Top investment officers of the California State Teachers' Retirement System have discussed moving as much as 12% of the fund's portfolio -- or more than $20 billion -- into U.S. Treasurys, hedge funds and other complex investments that they hope will perform well if markets tumble The board of the $191 billion fund, which is known by its abbreviation Calstrs, discussed the proposal at a meeting Wednesday. A final decision won't be made until November … Their countermoves in recent years -- which include a bigger shift into non-U.S. equities -- have left funds more exposed to problems around the world. State pension fund investments in foreign stocks have grown to 21% of their portfolios on average from 18.8% from 2008, according to the Wilshire. During the same period, holdings of U.S. stocks dropped to 27.9% of all public pension holdings from 38.1%. Holdings of real estate and private-equity funds rose."

-- The Wall Street Journal, September 2, 2015 (subscription required)

Pension funds, particularly the California State Teachers' Retirement System (Calstrs), are assessing the recent market volatility, per the excerpt above. On one hand, this is the type of capitulation that one might see at a bottom -- but note that in Calstrs' case such capitulation is being discussed, but hasn't occurred. If other pension funds act similarly in the months ahead, particularly those that might "front-run" Calstrs' November decision, this could prove to be a market headwind in the weeks ahead. The upside is that public pension fund holdings of U.S. stocks have dropped significantly since 2008, implying the potential selling power from these market participants isn't as great -- a potential longer-term positive.

For those with a long-term time horizon, the technical underpinning suggests higher volatility in the months ahead. There is a higher-than-normal chance that the market finishes lower 12 months from now, but higher volatility can also produce outsized advances. A potential takeaway is to reduce your market exposure. If the market rebounds and finishes significantly above the August close, you might consider increasing such exposure, based on a limited sample size of what has occurred in the past.  

For those with a short-term mindset, be sure you have exposure to short, sharp moves in either direction, especially with a Fed meeting on the calendar next week. 

Read more: 

Indicator of the Week: Why The S&P's Correction Has a Silver Lining

The Week Ahead: Apple Event Highlights Post-Holiday Week

What This Election Year Means for Stocks

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