Rather aimless, isn't it? After rising 14% in August on no news, the
Nasdaq Composite Index
has retraced most of that ground in September. It was down 9% from Sept. 1 through Sept. 12, again on no news. Days that start off with promise finish with a sad whimper; the Nasdaq was up 61 points just before noon on Sept. 12, but closed down 47 points for the day.
It's common to call a market like this "trendless," but while I think that term captures the net movement of stocks right now, it actually obscures the forces driving the financial markets at the moment. This market's trendless behavior is actually the end product of an overabundance of trends, each pulling in their own direction.
It's the push and pull of these trends -- and I can identify 10 that are likely to be in action -- that are likely to make September and October so volatile for individual stocks and the markets as a whole. Fortunately, those trends won't all be in action at the same time, and they won't all be equally strong throughout these months. I think if we lay out the trends, starting with those of the very shortest duration, we'll understand where this market might be headed and the possible timing of its ebbs and flows. And that will give us at least a fighting chance to make some money out of what is going to be a very, very difficult period.
10 Trends at Work
From short to long, here are the 10 trends that I see driving the market until the end of the year.
Options expiration on Sept. 15. Today is one of those
triple-witching Fridays when massive numbers of options and futures expire on the same day. These are all bets on the direction of the market and various indices, and with the clock ticking, traders go into a frenzy trying to lock in profits or to pull in a final buck. When the market is in a downtrend, the most promising way to bet is on a further fall in the market. That's what's made this week so incredibly volatile and slanted it so strongly to the downside. This is a nonissue going forward, except to the degree that options-related trading has made some stocks cheap.
Earnings-warning season. We've had huge warnings from companies like
. On Sept. 11, the company said it would break even for the September quarter, which would be well short of the 52 cents a share that analysts had been expecting. We've also had warnings from analysts about potential earnings shortfalls at high-profile companies such as
. This outpouring of bad news is par for the course at this point in the quarter, although it is having a bigger effect than usual due to general worries about earnings at technology companies. Actual earnings reporting for technology companies starts in earnest around Oct. 10, when
reports, and goes into high gear with
report on Oct. 17. Count on a scattering of earnings warnings to keep the worries alive for the next few weeks or so.
Overbought to oversold. Even if the market for technology stocks continues to gradually improve in tone -- the advance/decline ratio showed a healthy increase in the number of stocks participating in the most-recent rally -- and to gradually climb from the lows of March, we're still clearly in a range-bound market. This kind of market tends to rally quickly, as it did in August, and then sell off quickly, as it did the first two weeks of September. Near Nasdaq 4200, investors rushed to take profits. At 3800 or 3600, if investors follow recent form, they're likely to decide stocks are cheap and start buying again. This market could get cheap enough to bring back some buying as early as next week. It could start to feel expensive again in the middle of earnings season, or shortly after.
The September and October yips. Over the past 15 years, September and October have been, on average, the worst months for stocks. The calendar itself is partly to blame. As the days run by, investors will get a stream of reminders about the Great Crash of October 1929 and the Great Plunge of October 1987. It may not be logical -- hey, those were two horrible months in 70 years of Octobers -- but the anniversaries make investors skittish. And when they're jumpy, they tend to sell first and ask questions later.
Earnings worries. I doubt that the October earnings reports will be enough to put these to bed. Analysts have raised the possibility that a weak euro will hurt the dollar-denominated earnings of big U.S. consumer and technology companies. (Sales in euros will translate into fewer dollars of revenue, thanks to the exchange rate.) Sky-high oil prices will take a bite out of profits at airlines and other energy-intensive companies. Are we really seeing the first signs of a slowdown in the sales of telecommunications and networking gear by cash-strapped telecommunications service providers? I think we're likely to see continued swings from optimism to pessimism and back again on this one. Companies that disappoint will get savaged and will help take down their entire sectors. Encouraging projections or better-than-expected results will lead to sector-wide rallies. Thursday's (Sept. 14) earnings report from
was an important sign of how much a weak euro will affect technology-company profits. Going forward, a lot depends on the reports of technology leaders such as Intel,
Tax-loss selling. Since mutual funds close their books for the fiscal year on Oct. 31 in most cases, they are the first to kick off end-of-the-year selling to realize losses from stocks that are underwater. There are more than enough losses to go around this year, and I'd expect that money managers would be aggressive about selling enough stock to offset all their gains. (And the several major corrections that have occurred this year are likely to have generated significant profits to offset, as investors sold to protect long-term gains.) This tax-loss selling is a major cause of the market's historical underperformance in October -- and provides the fuel for the typical year-end rally.
The election. It looks tight right now, and that suits the bond market just fine. The last thing that market wants to see is a big spending spree, set off by one party or the other winning overwhelming majorities in both houses of
. And the bond market would, I suspect, be happy to see a continued split in control of the
. Calling elections certainly isn't my forte, but right now this one looks like it will have a positive effect on the financial markets.
Federal Reserve inactivity. It looks like
Mr. Greenspan and friends are out of the game for their November meeting, at least. I say that not because the inflation numbers are so convincing -- you can still make a case either way -- but because energy prices are threatening to jump completely out of control this winter. Of course, higher oil and gas prices are inflationary -- higher energy prices get factored into the prices of almost everything sooner or later -- and that's likely to concern the central bankers. But higher energy prices also exert a profound drag on economic growth. No one can predict exactly how much growth $35-per-barrel oil sucks out of an economy, but my bet is that the Federal Reserve, already concerned with figuring out how much its own interest rate increases have cut growth, will decide to watch and see rather than risk slamming the brakes on too hard. Federal Reserve inactivity is, at this point, a net plus for the stock market.
Climbing energy prices. The danger, of course, is that higher energy prices will take too much out of the economy, causing growth to stall. This doesn't actually have to happen to cause damage to the stock market. The mere repetition of this worry by enough pundits and analysts will make investors twitchy about earnings growth for the fourth quarter. And that could lead to stagnant, or even falling, price-to-earnings multiples in sectors dominated by companies that use a lot of energy.
The final healing of the bear's claw marks with a year-end rally. The recovery from a bear market tends to be characterized by rallies and corrections in a generally upward trading range. That's exactly what we've seen since March as each rally has been succeeded by a drop -- in May, July and now September. It takes a while before investors feel reasonably confident that this kind of quick correction isn't going to take the entire market back to the original low. In this context, a strong year-end rally, coming after nine months of gradual healing from the technology bear market that began in March, can gain momentum. If investors see the rally as a sign that the stock market is back to business as usual, they won't rush to sell at the first sign of weakness. And that could prolong any year-end rally.
Putting These Trends Together
Trends equal short-term volatility. In the short term -- that is, for September and October -- I think they add up to continued, and perhaps even increasing, volatility. For example, I expect that the current correction in the market for technology stocks will run its course, that these stocks will bounce and then perhaps sell off again -- all before the end of October. (And I expect that tax-loss selling will start earlier than usual this year and be stronger than usual.)
I also think that these trends support the possibility of a decent year-end rally. The customary bounce after tax-loss selling and the customary anticipation of holiday sales could drive this market higher. (The market could also get a positive push from the election and from continued Federal Reserve inactivity.) But the earnings picture, clouded by rising energy costs and a strong dollar, isn't strong enough to guarantee an end-of-the-year push. Right now, the odds don't favor enough of a strong end-of-the-year rally to justify taking added risks in your stock picking.
I think it's also important to realize that these trends won't affect all sectors equally. Some of the factors that are negative for the general stock market, such as rising energy costs, are positive for individual sectors. Research by the
Ned Davis Research Group
shows that when oil prices rise, sectors like oil drilling and services, domestic and international oil and natural-gas producers prosper. Sectors such as retail, household furnishings and appliances, restaurants, transportation and leisure suffer.
And given the volatility implied by these trends, it's certainly a good time to think about the trade-off in your portfolio between risk and reward. For example, high-P/E growth stocks are extremely vulnerable to earnings disappointments -- and this period looks like it will be chock-full of them. On the other hand, these stocks are also the ones that will show the biggest gains if the end-of-year rally turns out to be a strong one.
Any near-term rally in September or October would be a good opportunity to reduce your portfolio's risk to a level that feels comfortable. Any technology rallies during that period would be a good chance to reduce exposure to the sector if your portfolio is still overweighted in that direction. As I read the big picture, technology will be the most exposed of any single sector to the negative trends among the above 10, and the most likely to show extreme volatility. I have no intention of eliminating technology from Jubak's Picks or of abandoning all my price- or earnings-momentum choices, but I certainly wouldn't mind lowering the potential risk in this portfolio a tad on any near-term rally.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Atmel, Cisco Systems, Intel, Microsoft, Nokia and Nortel Networks. He welcomes your feedback at
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