In a nutshell, August has been pretty volatile for the stock market this year. In this article, I will try to describe in practical terms how our technical analysis of the stock market, combined with the fundamental analysis of economic data, results in our quantitative and repetitive analysis of financial markets. Our quantitative analysis aims to position our portfolios in the same direction as the stock market, never against it. It makes sense, but not many people do it.
Several factors have influenced the stock market behavior during August:
- Interest Rate Expectations: Investors are closely watching the Federal Reserve (Fed), anticipating the first potential interest rate cut in September.
- Economic Data: Mixed economic signals, such as soft manufacturing and jobs data, initially caused concerns about a potential recession. However, positive earnings reports later in the month helped stabilize the market—at least at the end of the month.
- Global Events: A surprise rate hike from the Bank of Japan added to the volatility, affecting global markets and contributing to the initial sell-off in U.S. equities.
- Seasonal Patterns: Historically, August and September have been mixed for stocks, with no solid directional bias. This can lead to unpredictable market movements. Note that September is historically the most negative month for stocks.
- Low Trading Volumes: With many traders on vacation, trading volumes are typically lower in August, which can amplify market swings and increase volatility.
In my last article from August 2, I wrote: “I continue to be bullish on the long term (6-12 months). However, to reach the long-term target, we must first go through mid- and short-term periods, which I expect to be volatile.” The positioning of our portfolios reflects our long-term bullishness and prudence as we approached August and now, volatile September. This results from our quantitative process, the combined analysis of technical indicators and fundamental (economic) data.
From a practical technical perspective, at the end of August, the Dow was coming off of its all-time high, the S&P was very close to its all-time high, and the NASDAQ continued to struggle and lag as traders moved away from large-cap tech stocks. During August, the stock market hasn’t been kind to those who have remained loyal to their big-cap tech positions, but plenty of stocks in other sectors have benefited from the recent rotation of capital. These stocks have fueled the recovery from the early August trough, keeping the S&P 500 Index afloat and almost at its all-time high.
I expect the stock market to remain range-bound and move horizontally as the country approaches election day on November 5th and uncertainty remains. The S&P 500 may retest the August lows, but I doubt it will enter a bear market, not even a cyclical one. During August, the best three performing sectors were utilities (XLU), consumer staples (XLP), and real estate (XLRE). These are the most defensive sectors in the U.S. economy. This type of leadership is associated with cautious investors and an economy transitioning into a slower GDP. The mentioned leaders were followed by technology (XLK), health care (XLV), financials (XLF), industrials (XLI), materials (XLB), communications (XLC), consumer discretionary (XLY), and energy (XLE) the only negative performer for the month.
What is technically necessary for the stock market to maintain a bullish trend and avoid a bear market? Leadership from technology and consumer discretionary. This is important because the former makes up 50% of the Nasdaq 100 Index, and the latter makes up about 5/8 of GDP. We also need volatility to remain lower, ideally below 17 or 18. The short-term, mid-term, and long-term trend of volatility remains bullish. This indicates that the stock market will probably remain volatile during September and perhaps even part of October.
How do we connect the stock market behavior with the economic data? Let’s get into it. The economy is more robust than we thought it was. Despite downward revisions in several categories, second-quarter GDP growth was revised higher, from 2.8% to 3.0%. As is often the case, consumers came to the rescue. All three components of consumption — durable goods, nondurable goods, and services — were revised higher, lifting the overall consumption rate from 2.3% to 2.9%, more than enough to offset the downward revisions elsewhere.
PCE is the inflation data the Fed likes to examine. July PCE and core rose 0.2%, as expected. The year-on-year PCE was unchanged at 2.5%, while the core was unchanged at 2.6%, a tenth better than expected. After benign CPI and PPI data, a friendly PCE reading was expected. This is important because these are Fed-friendly numbers and support the FOMC’s decision to start easing at the next meeting.
In general, commodities, including copper and oil, are in short-term bearish trends, which supports the above case of decelerating inflation. However, GDP was revised higher. Therefore, why would the Fed lower interest rates if the economy is not in trouble? Perhaps because unemployment is increasing and we have a presidential election in two months, which the incumbent vice president wants to win.
Conclusion: The rate cut in September has been clearly announced. In my last article, I mentioned that the question is, what happens next? And the question remains. Even if the Fed flips and does not cut rates after September, as long as GDP accelerates and inflation continues in a downtrend, the economy is in Phase I. The stock market does not collapse when financial markets anticipate the economy entering Phase I. On the contrary, it moves sharply up. For this to happen, the mentioned capital rotation must occur first, and the volatility trend must weaken, dropping below 20. It is of utmost importance to watch these moves in addition to the inversion of the yield curve, which is now, as we anticipated, slightly positive between the 2-year yield and the 10-year yield, to determine the direction of the next trend of the S&P 500 and, therefore, how much capital at risk it is prudent to allocate in portfolios.
Today’s quantitative result (combined technical and fundamental analysis) indicates that the stock market will probably remain within a limited price range but with volatility. The key word is “probable” because financial markets only allow probability calculations. Everything is possible; however, the important thing is to determine the degree of probability of a potential scenario. Without an efficient quantitative analysis and understanding of the internal movements that define the trend of financial markets, it is like blindly playing a very high-risk game.
Currently, subject to change as new data becomes available, our worst-case scenario shows S&P 500 support in the 5100 to 5200 range, indicated as “Main Support” in a red rectangle. The indicator below the chart shows the volatility index in the 20 range (red circle).
With best wishes,
