The recent market downturn has many people wondering if this is the start of a bigger correction or just an upheaval before a rally in the fourth quarter. I lean towards the latter for the following reasons: seasonality, Fed, technicals and sentiment.
Seasonality is negative in the short term, but positive until the end of the year. From around mid-September to around mid-October, factors such as index rebalancing and quarter-end portfolio adjustments can cause seasonal weakness. These factors, along with concerns about the debt ceiling, are currently contributing to market volatility.
When we get out of it, we’ll start one of the strongest seasonal times of the year. According to the Stock Trader’s Almanac, October has traditionally been strong, but after the volatility and weakness at the start of the month. Next, November and December are two of the three strongest months of the year (according to data since 1980). Market participants just need to be patient as we go through some short-term seasonal weakness.
Chart provided by MarketSmith.
The Federal Reserve meets every six weeks to discuss monetary policy. At their next meeting in November, they are expected to announce their “reduction” schedule. This is their plan to cut the $ 120 billion in monthly bond purchases that began in the spring of 2020 as the coronavirus pandemic took hold.
My feeling is that they won’t start declining until the start of 2022, and even if they start earlier, their reduced purchases will still provide a substantial amount of liquidity in the markets. Moreover, their near-zero interest rate policy will likely remain until 2023. Ultimately, the Fed will continue to provide the backdrop for a favorable environment for equities.
For the most part, the S&P 500 has maintained its 10-week moving average since mid-2020. This technical average is important as it is an area of institutional support. The index closed slightly below this level recently, but I expect it to return to that level once we get through this seasonal period of weakness. Additionally, the Nasdaq Composite continues to hold a key area around 14170-14180. As the chart below shows, I see this recent pullback as a further test of previous highs in February and April.
The chart is provided by MarketSmith.
There are also many sectors that continue to do well. Finance and energy are near 52-week highs, and growth sectors such as semiconductors, medical products, retail and software are building technical foundations. Many stocks in these groups have seen bullish option activity recently, showing that large institutions are speculating on higher prices until the end of the year.
There is an old adage that the market tends to fool the majority. Right now, many market participants have a foothold. Several opinion polls continue to show that investors hold high levels of cash and consistently buy puts on every drop. From a contrarian perspective, this constant fear prevents the market from seeing an aggressive follow-up of the sell.
In the short term, the greatest requirement is patience, as the market still has to go through this period of seasonal weakness. As a result of this, we will enter a traditionally strong period for being in the market. The favorable backdrop for equities provided by the Fed should help propel the market to new highs by the end of the year. If you trade individual stocks, stay focused on stocks with the strongest technical and fundamental characteristics, and always manage the risk if a position turns against you. Good luck!
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