Stocks: A Leadership Shift Into A Historically Tough Seasonal Stretch
September 2024
August was a choppy, albeit profitable, month for investors in large cap U.S. stocks as a sharp selloff early in the month on the Japanese yen carry trade unwind was quickly followed by a sharp rebound mid-month with the S&P 500 ultimately gaining 2.2%. The ‘Magnificent 7’ was a source of funds during the month as investors reduced exposure to this year’s biggest winners and put capital to work in defensive (health care, consumer staples) and interest rate sensitive (financial services, real estate, utilities) sectors as Treasury yields fell amidst signs of softness in the jobs market which called into question the outlook for U.S. economic growth. While fears that labor market weakness could translate into weaker consumer spending, slower economic growth, and weigh on corporate profitability in the coming quarters were making the rounds, S&P 500 participation/breadth remained impressive and over 75% of index constituents were trading above their 50- and 200-day moving averages at month-end.
Encouragingly, strong breadth readings put the market on firmer footing as we enter a historically weak seasonal stretch -- from September into late October -- for stocks in presidential election years. The S&P 500’s ability to quickly recover from the early-August doldrums and shrug off post-earnings weakness out of ‘Mag 7’ member Nvidia to close out the month within 1% of an all-time high makes it difficult to be anything but constructive on U.S. stocks, particularly with the equal-weighted S&P 500 making an all-time high as August ended. But with earnings season in the rearview mirror, and with a quarter-point rate cut in September priced in and potentially a ‘sell the news’ event should the FOMC move more aggressively and cut by 50-basis points, upside catalysts for U.S. stocks are more difficult to identify and appear limited in the near-term.
The U.S. Dollar Index (DXY) fell from $104 at the end of July to $101 at the end of August, taking its two-month loss to 4.2% as demand for the greenback has waned amid fears of a U.S. economic slowdown and as expectations the FOMC would cut, perhaps aggressively, in mid-September have risen. U.S. dollar (USD) strength is a double-edged sword as it highlights demand for dollars and U.S. economic strength but has historically acted as a modest headwind for U.S. large-caps stocks which derive approximately 40% of their revenue from overseas. The recent decline could boost S&P 500 revenue this quarter but, given the velocity of the recent dollar decline and seasonal factors in play, a reversal of the downtrend or stabilization could materialize in the coming months. Seasonal trends over the last 20-years show the greenback typically gaining ground from August through October before weakening modestly in November through December. In presidential election years, those seasonal stats hold as over the last four presidential cycles the dollar has moved lower in the 4th quarter by an average of 1.5%, likely a product of policy uncertainty that often proves less impactful than feared.
Should the U.S. dollar find its footing in the near-term, small and mid-cap (SMid) stocks, which have lagged as fears of a U.S. economic slowdown have grown, could fare a bit better as a relative beneficiary of U.S. dollar strength, and exposure to SMid remains warranted for diversification purposes, particularly if one views the dollar’s decline as overdone. Where the dollar closes out the year is anyone’s best guess given elevated political and monetary policy uncertainty, but by maintaining a diversified portfolio across market cap and geographies, investors should be well positioned to ride out currency volatility and react accordingly should market dislocations arise.
Equity Markets Abroad Beneficiaries Of The U.S. Dollar’s Slide. The U.S. dollar’s August slide provided a tailwind for equities outside of the U.S. in August with developed markets benefiting the most. Country indices tied to Germany, Italy, Spain, and Switzerland all generated returns north of 4.5% on the month in U.S. dollar terms. Strong monthly gains abroad can be attributed largely to the falling U.S. dollar relative to the euro and Swiss franc as currency translation effects propelled the MSCI Germany USD index, specifically, to return 4.7% in August versus just 2.4% for the local currency index. Strong relative performance out of international developed markets could prove short-lived should the tailwind from a weaker U.S. dollar wane in the coming months, in keeping with historical patterns. Longer-term fundamental headwinds such as lackluster earnings growth along with regulatory and political uncertainty abroad remain, which prevents us from getting too constructive on international developed market stocks despite appealing valuations and dividend yields, leaving us neutral relative to our strategic benchmark.
Emerging market equities on the other hand have been building momentum in recent months as the fundamental outlook outside of China has improved as the U.S. dollar has weakened, and relatively attractive valuation metrics including a one-year earnings growth estimate of 31.9% and a 12-month forward price-to-earnings (P/E) ratio of just 13 have garnered interest from relative value and growth investors alike. Though we’re receiving positive signals out of the broader EM asset class, dispersion at the country level leads us to favor a more active approach as even in August the best performing EM country, Brazil, posted a 5.5% gain, while the worst performer, Mexico, notched a 5.4% decline. The remaining pieces of the puzzle to make us more bullish on emerging market assets lie with better technical breadth and improved relative strength readings, which would be signs that investors are appreciating recent fundamental improvements in the space and are allocating capital accordingly.
