After spending much of May through July in a tight trading range, the market began August with a brief, sharp rally. That rally fizzled during the second half of the month, due largely to rising interest rates and uncertainty surrounding Federal Reserve policy. Despite solid gains for the year, the market has struggled to sustain much traction outside of the torrid rally in April and May. In fact, the S&P 500, which is up 12.5% for the year as of this writing, would be negative for the year excluding those two months. This dynamic is not entirely unusual, although this year’s uneven returns have been more pronounced than normal. It underscores the importance of patience and staying invested, particularly given that few investors were bullish at the end of March as the conflict with Iran intensified.
One of the most encouraging developments over the past few months has been the broadening of the market. It is no longer accurate to say that market gains are concentrated in the hands of a few dominant technology companies. The equal-weighted version of the S&P 500, which reduces the influence of the largest technology companies, has outperformed the traditional market-cap-weighted index for the year through August. Small-cap companies, as measured by the Russell 2000, are up more than 20% this year as of this writing, while formerly lagging sectors such as Energy, Materials, and Healthcare have come back to life (all data according to Morningstar). Bull markets are generally healthiest when participation is broad, and this expanding participation is a key pillar of our view that the market remains in a long-term uptrend.
Interest rates continue to be one of the more complicated issues facing the market. We have written and commented extensively that the economic data and inflation indicators do not support a return to a 2022-like inflation problem. We have also noted that it may take markets some time to acclimate to Kevin Warsh’s new communication style, and that uncertainty itself can put upward pressure on interest rates. But there is more to the interest-rate story than inflation and Fed policy.
The AI investment boom has contributed to a flood of new corporate bond issuance, while U.S. fiscal policy continues to produce large federal deficits and substantial Treasury borrowing needs. Both factors increase the supply of bonds competing for investor money, which can put upward pressure on longer-term yields. That dynamic may complicate the Fed’s job and could contribute to additional rate increases later this year, even without a meaningful resurgence in inflation. However, absent persistently rising inflation, we believe it is unlikely that the Fed is beginning another multiyear hiking cycle. Historically, shorter-lived, mid-cycle increases in interest rates have often been followed by strong stock-market returns.
Corporate and economic fundamentals remain strong as well. Earnings growth has continued to be spectacular, while the broader economic data to this point show little evidence of a meaningful slowdown. The high-yield bond market, which is often among the first areas to show stress when economic conditions are deteriorating, has also performed steadily throughout the year. Short-term risks should therefore be viewed in the context of a fundamentally healthy underlying environment.
In the shorter term, however, we do believe the market is vulnerable to a pullback in September and/or October. The market’s muted reaction to spectacular earnings from its largest component, Nvidia, as well as to the Jackson Hole conference, raise mild short-term concern. When potential positive catalysts do not result in a rally, it shows that the market is more vulnerable to a decline on any bad news. We have written throughout the year about the various risks overhanging the market, including geopolitical uncertainty, questions surrounding the AI investment cycle, interest-rate policy, and the upcoming midterm elections. September also has historically been the weakest month of the year for stocks, averaging a decline of approximately 1.2% since 1928, according to Dow Jones data.
We recognize the risk of overstating the case for a near-term pullback given the strength of the fundamentals and the positive alignment of our longer-term indicators. We are not predicting that a correction must occur. Rather, if the market is going to experience a meaningful pullback this year, we believe the September-October period represents the most likely window for one. We want clients to be prepared for that possibility so that normal market volatility does not become a source of unnecessary concern.
More importantly, the weight of the evidence continues to suggest that any pullback in the coming months would most likely represent a temporary setback within an ongoing bull market rather than the beginning of a sustained downturn. We will continue to follow our investment process to guide client portfolios through any volatility, including identifying potential buying opportunities as they emerge.
This is being provided solely for informational and illustrative purposes, is not an offer to sell or a solicitation of an offer to buy any securities. The factual information given herein is taken from sources that we believe to be reliable but is not guaranteed as to accuracy or completeness. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Employees of Janney Montgomery Scott LLC or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed here.
