Stocks face a huge test in September following sluggish summer gains

Investors would be well-advised to get some much-needed rest over the Labor Day weekend after enduring a grueling summer of interest rate debates at the Federal Reserve, unprecedented swings in presidential elections, a historic spike in market volatility and a pullback and a August’s chaotic rebound.

A dizzying flurry of events capped by a curiously disappointing Q2 earnings report from Nvidia (NVDA) last week, it left stocks holding on to modest, and possibly weak, gains into the final month of the third quarter and what could be a critical period for U.S. stocks through the end of the year.

The Fed’s first fall rate meeting, which ends on September 18, is probably the biggest risk event of the quarter. Investors will then focus on the first set of third-quarter earnings reports, the latter part of the US presidential election season and the continued impact of the war in Ukraine, Israel’s war in Gaza and China’s renewed threats to Taiwan.

But while the first of these events is likely to capture most of the market and media attention, it may not be the engine for near-term stock gains that some expect.

Bull market or bearish pullback? Wall Street is divided at the end of the year.

Michael M. Santiago/Getty Images

An in-line reading in the Fed’s preferred inflation gauge, the PCE price index, for July largely cemented bets that the Fed will begin a series of interest rate cuts, the first in four years, next month in Washington.

“How many pieces of gold are there”

“This is as Goldilocks as it gets,” said Jamie Cox, managing partner for Harris Financial Group in Richmond, Virginia. “The consumer remains strong and disinflation is clear.”

“However, there is no justification for (a half-point rate cut) in September,” he added. “The Fed will be able to normalize rates slowly, in quarter-point increments.”

While that may be true, rates collected from CME Group’s FedWatch tool suggest the federal funds rate will drop at least a full percentage point to 4.375% by December, with more cuts planned for the first quarter of next year.

Related: Inflation report reinforces rate cut bets

This likely means at least an excessive rate cut, either immediately after the November election or at the December meeting, to meet the market forecast.

The problem, though, is that regardless of the pace, stocks typically don’t do well following a Fed rate cut cycle, according to LPL Financial chief technical strategist Adam Turnquist, although they tend to move higher in a medium term horizon.

Rate cuts often signal pullbacks

“Based on the last nine major rate hike cycles since the 1970s, the S&P 500 has produced mixed, modest returns in the three months since the first rate cut, with 12-month mean and median returns of 5.5% and 10%, respectively .8%.” Turnquist noted.

“Furthermore, the 12-month peak draws after the first drawdown were around 19%-20%, larger declines than the average peak drawdown for all years since 1974 of 14.4%,” he added. “Of course, how the economy holds up and whether we enter or avoid a recession will ultimately dictate how stocks perform over the long term.”

The jury on that verdict, however, remains deadlocked in tense deliberations. The Commerce Department last week pegged growth at 3 percent in the second quarter, a firmer-than-expected update due in part to a surprise increase in consumer spending.

Related: Housing market looks for Fed rate cut as sales fall and prices rise

However, weaker labor market data, some stark warnings about spending trends from top US retailers and the typical uncertainty heading into the latter part of an election cycle added to concerns that overall growth is slowing suddenly until autumn.

The Atlanta Fed’s GDPNow forecaster pegs current-quarter growth at 2.5 percent. That level is likely to decline in the coming weeks as broader activity cools following the Fed’s rate hikes over the past two years.

That brings into focus this week’s round of labor market data, including the crucial August nonfarm payrolls report on September 6.

Job data in focus

Elizabeth Renter, senior economist at consumer advocate NerdWallet, said the collective reports could underscore the current narrative of the cooling market, but she doesn’t expect any major surprises.

“I don’t anticipate an increase in the unemployment rate, given that initial claims have been fairly steady, and while we may see more jobs added this month than last, the overall trajectory will remain low compared to the year past and even early 2024,” she said.

Corporate earnings growth is also set for a slowdown in the third quarter, with collective S&P 500 profits forecast to rise 5.1%, down sharply from the 12.7% pace in the three months ended June, according to LSEG estimates.

Related: Nvidia earnings key to market rally after Fed puts rate cards on table

Data tracking streams from the world’s biggest fund managers also suggest a defensive tenor heading into the fall. Bank of America’s weekly Flow Show report notes an $8.4 billion move into Treasuries, the biggest in nearly a year, with another $24.5 billion allocated to high-yield cash assets.

LPL’s Turnquist also points out that September has historically been a challenging month for US investors, with weak trading in the opening weeks giving way to weakness as the third quarter draws to a close.

Optimistic scale or declining technology?

“Since 1950, the S&P 500 has generated an average return of -0.7% in September and finished higher just 43% of the time, making it the worst month for stocks based on average return and rate positivity,” Turnquist said.

“The past four Septembers have also been very weak, with the index posting declines of 4.9%, 9.3%, 4.8% and 3.9%.”

On the plus side, the breadth of the market has improved considerably since the Magnificent 7’s dominance in the second quarter, with about 70 percent of U.S. stocks outperforming the S&P 500 since June, according to Bank of America data.

In fact, since the start of July, Magnificent 7 stocks have collectively fallen 10.2%, while the other 493 stocks in the S&P 500 have risen 4.1%

Coming off a recent streak in the Dow Jones Industrial Average that ended at a record high last Friday, Ryan Detrick, chief market strategist at the Carson Group, identified an interesting quirk.

“Since 1900, the US economy has been in recession 22.4% of the time…but six months after a new all-time high in the Dow, it has only been in recession 8.9% of the time?” Carson wrote in a recent blog post.

More economic analysis:

• Kamala Harris sees market stars aligning against Donald Trump
• The CPI report upsets the bet on a big Fed rate cut
• Main Street business is pushing Wall Street into recession

“The last time it made a new high during a recession was in late 1982, which started a huge market,” he added.

Enjoy the long weekend. But be in your seats and ready for class when the market resumes on September 3rd.

Related: Veteran fund manager sees world of pain coming for stocks