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Schwab: Is Seasonal Volatility Ahead?

September 23, 2021

 

September and October have historically been blustery months for stock market performance. While some well-known market drops have occurred during October—think 1929’s “Black Tuesday” and 1987’s “Black Monday”—fears about the so-called October effect are generally overblown. Nevertheless, since 1900 the Dow Jones Industrial Average has ended the September/October period higher only 48% of the time, with an average return of negative 0.7%.

Are we in for a bumpy ride this year? Possibly. Because of the COVID-19 delta variant, fiscal policy uncertainty, stretched investor sentiment, and a still-recovering job market, the volatility risk is heightened.

Stocks have been up only 48% of the time in September/October

Source: Charles Schwab, SentimenTrader. 1900-2020. Table looks at performance achieved by holding the DJIA every year, but only during the indicated starting and ending months. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.

U.S. stocks: churning beneath the surface

So far, 2021 has been a great year for equity investors, but gains have been mostly associated with major market averages like the S&P 500, which has been up for seven consecutive months. Beneath the surface, there has been a significant amount of churn and a progression through at least three distinct phases since the beginning of the COVID-19 pandemic. Market breadth has recently deteriorated, with fewer stocks trading above their 200-day moving averages. There have been significant declines at various points this year in highly-speculative/non-traditional segments of the market; including popular meme stocks, nonprofitable technology stocks, special purpose acquisition companies (SPACs), cryptocurrencies, heavily shorted stocks, and recent initial public offerings (IPOs).

That doesn’t mean stocks can’t continue to perform well, but these are red flags. Given myriad uncertainties, we believe investors should focus on the tried-and-true disciplines of diversification (across and within asset classes) and periodic rebalancing. Rebalancing is particularly important when volatility picks up, as it pushes investors to trim certain holdings into strength and add into weakness—in other words, selling high and buying low.

For the active stock-pickers out there, we have been highlighting all year a bias toward factors over sectors—in other words, looking at stocks through a lens that uses factors such as free cash flow yield, balance sheet strength,  sales growth, and forward earnings estimates; rather than simply focusing on whether the stock falls into the “growth” or “value” bucket. In particular, we think the focus should be on high quality, blending both value- and growth-oriented factor analysis.

International stocks may outperform over the long term

A new cycle of economic expansion could bring new leadership by international stocks relative to U.S. stocks, supported by better-than-average global growth and lower stock valuations.

COVID-19 concerns have weighed on the global growth outlook, prompting a rotation this summer to more-defensive stocks, which tend to perform relatively well when economic growth is slowing. However, signs that the delta variant may not derail growth could mean a rotation back to cyclicals—which historically have outperformed when economic growth accelerates—this fall. Cyclical stocks, which tend to dominate international indices such as the MSCI EAFE Index, often perform best when the growth outlook improves.

European stocks have posted gains for seven months in a row. Markets have continued to experience buy-the-dip rallies, with investors using pullbacks to jump back into the market without waiting for bigger drops—despite the COVID-19 delta variant, supply-chain delays, and expectations that central banks and governments will soon taper economic stimulus.

Meanwhile, Chinese stocks have fallen into a bear market, driven by concerns about regulatory reforms. But the drawdown is in line with the longer-term average, and the intensity of new regulations may ease, providing some relief to stocks. New regulations and bear markets in China are not new. The high volatility that can result has been accompanied by double-digit annualized returns over the longer term.

All of this underlines the importance of global diversification. Because market leadership and trends can change quickly, consider whether your portfolio is appropriately diversified across a variety of asset classes, including both domestic and international stocks.

Fixed income: Fed tapering is likely to begin this year

Despite an unexpectedly weak August jobs report (when U.S. payrolls grew by only 235,000 jobs, well below expectations for a 725,000-job gain), the Federal Reserve likely will slow the pace of its bond purchases this year. Since March 2020, the Fed has been purchasing Treasuries and agency mortgage-backed securities (MBS) to support the economy—by buying bonds, it puts cash into the financial markets and helps keep longer-term yields low. Assuming the labor market remains relatively strong, we expect a tapering announcement soon.

That doesn’t mean the Fed will rush to raise short-term interest rates, however. The Fed’s key policy rate, the overnight federal funds rate, has been in a range of zero to 0.25% since March 2020, and we don’t expect the Fed to raise that rate before late 2022 or 2023.

Meanwhile, longer-term Treasury yields probably will rise. Longer-term yields are driven largely by market expectations for inflation and economic growth, and we expect 10-year Treasury yields to rise later this year and in 2022 as economic growth continues and inflation rises (remember that bond yields move inversely to bond prices, so when prices fall, yields generally rise). Also, the Fed owns a large amount of Treasury Inflation-Protected Securities (TIPS)—if it steps away from the market, TIPS yields could rise and further drive up yields in the 10-year Treasury bond market.

So should you avoid bonds? Not at all. Treasuries generally don’t move in tandem with stocks, which has made them a safe haven, historically, during times of market stress. If yields rise, total returns for bond investments likely will be driven by coupon income, not price appreciation.

For now, we suggest fixed income investors consider keeping average duration—a measure of price sensitivity—below the benchmark average, given our outlook for rising long-term yields. If the 10-year Treasury yield does rise as expected, investors should then consider adding some intermediate-term bonds to take advantage of higher yields.

 

 

Source: https://www.schwab.com/resource-center/insights/content/quarterly-market-outlook