Seasonality, Politics and the Death of the Momentum Trade
Conditions for a difficult September are in place, but it will also create new opportunities.
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The market is digesting the fallout from last week’s Nvidia (NVDA) report and Kevin Warsh’s Jackson Hole speech Monday morning. Both events created new problems rather than resolving them.
The Nvidia report was great for Nvidia. It was considerably less good for the customers who now have to pay higher prices for chips that Nvidia itself said are getting more expensive. And Jackson Hole made it clear that Warsh carries a stronger hawkish bias than the market anticipated, which sent the odds of a rate hike sharply higher.
These two key events are hitting at the same time we move into historically the worst month of the year for the market.
The September Numbers
Since 1928, the S&P 500 has averaged a decline of about 1.1% in September. February is a distant second at negative 0.1%. September has finished lower roughly 55% of the time versus 39% for every other month. Nine of the 40 worst monthly losses in the past century occurred in September.
However, when the S&P enters September above its 200-day moving average, the average return for the month flips to positive 1.3%, with 60% of those Septembers finishing higher. When it enters below the 200-day, the average decline is 4.2% with only 15% positive. The S&P 500 is well above its 200-day moving average currently.
It is important to note that seasonality is a tendency and not a certainty. There are many exceptions, but in the current case we have several negative catalysts aligning with the seasonal tendencies and that makes me more cautious than I would normally be. Seasonality is often self-fulfilling and in this case, market players already have some good reasons to be more bearish.
The Momentum Trade Has Broken
The Wall Street Journal published something over the weekend that confirms what I have been writing about all summer. The S&P 500 Momentum Index has fallen more than 9% since July 1 while the S&P gained 2.8%. It is on track for its biggest quarterly underperformance in 25 years. July was the second-worst month for the momentum trade in roughly 40 years according to Bank of America (BAC), and the only worse month was April 2009, in the middle of the financial crisis.
That is a violent reversal in a strategy that had been working extraordinarily well. The momentum index rose 44% in the second quarter, its best quarter on record, and 133% over five years, nearly double the broad market.
Hedge funds have been hit hard by the momentum reversal. Goldman Sachs (GS) said the basket of most popular hedge fund holdings had its biggest one-month underperformance against the S&P in more than 20 years during July. August 19 was the worst day for systematic long-short managers in over two years, with about half the losses coming from momentum trades.
This is the hard proof of the rotational action and the deception of the indexes that I have been yammering about for months. When money moves from group to group without leaving the market, momentum stops working, because the leaders keep changing before the trend can establish itself.
The Moderna (MRNA) squeeze was a perfect illustration of how hedge funds can find themselves trapped. It was among the most heavily shorted names in the market when positive news sent it up roughly 150% for the month, and it destroyed the funds positioned against it.
The news on this front is not all bad. Speculators have pushed net short positions in Nasdaq 100 futures to some of the highest levels in the past two decades. That is jet fuel for a squeeze if the market turns and they are forced to reposition.
The Bull Case Is Real but It Is Not for Now
While the momentum trade is blowing up, there is also something positive. According to the WSJ, corporate profits are booming. S&P 500 per-share earnings rose 53% in the second quarter with sales up nearly 16%. Even excluding investment gains at Amazon (AMZN) and Alphabet (GOOGL), earnings rose the most since the fall of 2021. More companies raised guidance than lowered it by nearly two to one, which reverses the pattern from a year ago.
Part of that is temporary. Tariff refunds are expected to generate more than 4% of third-quarter economic growth, a big boost for companies such as Walmart (WMT), which received roughly $2.9 billion.
That earnings power is what gives the bulls some comfort but it does not help much in the near term. It helps when we get closer to third-quarter earnings and the market starts anticipating good numbers, but this is why negative seasonality matters now. We have at least a month before investors will start to anticipate earnings.
Politics
One more issue to consider is that the midterm election occurs on November 3, and the seasonal pattern around midterms is more pronounced than the September effect by itself. Since 1962, every one of the 16 midterm cycles has seen a decline between mid-August and Election Day. Not most of them. All 16. The average drawdown was 8.1%, and 10 of those 16 put in their low in October.
Midterm years are also the weakest phase of the four-year presidential cycle. The S&P has averaged about a 4.6% gain in midterm years since 1950, versus roughly 9.1% for all years, with deeper intra-year drawdowns along the way.
The good news is that since 1950 the S&P has been higher 12 months after every single midterm election, 19 out of 19. The weakness comes before the vote, and the strength comes after it.
Game Plan
My positioning has not changed. I’ve noted numerous times that my cash level is high, I am selective with new buys, and I am moving slowly and incrementally.
The seasonal pattern is unfavorable, the Fed just leaned hawkish, and the momentum trade that carried this market has stopped working. Those three things arriving together is why I have been cautious for weeks. The poor action on Friday confirmed that some significant problems exist.
What keeps me from being outright bearish is the earnings picture and the calendar beyond September. October is known as the bear killer because historically it is when the market has made its final lows. It isn’t just a coincidence that third-quarter earnings arrive in the same window.
The setups I want to buy are going to come out of the next few weeks of pressure so I’ll be working my shopping list.
At the time of publication, Rev Shark had no positions in any securities mentioned.
