September is the toughest month for stocks, but this time could be different

September is the worst month, but it may not matter.

It's an old trader saw: September is the worst month of the year.

It's true. Since 1945, September has been the worst month, on average, for the S&P 500:

S&P 500: worst months
(Avg. since 1945)
September down 0.56%
February down 0.15%
August up 0.03%

Source: CFRA

Here's the problem: It hasn't worked very well recently. September has been up three of the last four years:

S&P 500: September
2020: down 3.9%
2019: up 1.7%
2018: up 0.4%
2017: up 1.9%

A lot of the old seasonal trading rules (sell in May and go away, the January effect, best six months trade, etc.) have not worked as well in the last few years.

Some believe these old saws are being disrupted by the oceans of cash the Federal Reserve has been showering on the economy since the financial crisis in 2008.

"There is so much liquidity out there," Art Cashin from UBS told me.

September setup: About as good as it gets

Regardless of September fears, the setup is about as good as it gets. The three issues of most concern to stock traders — earnings and the direction of earnings estimates, profit margins, and interest rates — are aligned favorably:

Why stocks are at new highs
Earnings: record
Earnings estimates: still rising
Margins: record
Interest rates: remain low

Strategists have been particularly impressed with the steadily increasing earnings estimates.

"It appears that we have underestimated the earnings power of US stocks yet again despite bumping up our 2021 EPS target back in May," BMO's Brian Belski wrote in a note to clients. "And with analysts continuing to raise annual EPS estimates we believe our current EPS target is again likely too low."

Another factor in the markets rally has been persistent rotation into and out of key groups.

For much of the first half of the year, small-cap stocks outperformed big caps, and value (mostly industrials, materials, banks and energy) outperformed growth (mostly technology).

That has reversed in the third quarter, as big caps and growth have returned to dominance:

Q3: Major indexes

S&P 500: up 5%
S&P Small Cap: up 2%
Growth: up 8%
Value: up 2%

What's not to like?

Even with the market at new highs, there are signs that the rally is being pushed ahead on fewer stocks. Traders always prefer "broad" rallies, so this is a sign of some concern.

NYSE advance/decline line: topped in June. With the S&P 500 at new highs, this is a sign the rally is getting more selective.

New highs: peaked in March. "Fewer stocks are able to keep pace with the major indexes and this leaves the market in a fragile state, susceptible to increases in Supply," Lowry Research's Michael Kahn wrote in a recent note to clients. Lowry is the nation's oldest technical analysis service.

Momentum (S&P stocks above 200-day moving average):Steadily declining since it hit a top in February, at 91%. Now only 58% are above their 200-day moving average.

What's all this mean? The markets are remaining at new highs, but only because we are back to the situation where a small group of the largest companies are keeping the market afloat.

The S&P 500 is up 5% this quarter, but the five largest stocks in the S&P are up an average of 10.2%.

Five largest S&P 500 companies
(QTD)
Apple: up 12%
Microsoft: up 12%
Alphabet: up 18%
Amazon: flat
Facebook: up 10%

Meantime, many stocks are lagging. Only 62% of the S&P 500 is up this quarter.

The 'endless bid' in the markets

Far from being happy, many traders are baffled by the relentless move up in stocks.

"There's just an endless bid to the markets," one trader who asked to remain anonymous told me.

The problem: Even as they acknowledge the strong earnings backdrop, the combination of the Fed and the delta variant tells many the markets should be lower.

Jonathan Corpina of Meridian Equity Partners Traders said he understood the apprehension, but so far the markets are choosing to put a positive spin on the delta variant and the Fed.

"The market is telling us that the Covid variant is not going to shut down the economy, and [Fed Chairman Jerome] Powell has now convinced everyone that there is very little chance of the Fed suddenly raising rates," he said.

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