Investors must reckon with the likelihood that the worst is yet to come
The floor of the New York Stock Exchange.
Spencer Platt | Getty Images
August and September are historically the worst months for stocks. That was the case this year, how the S&P 500 index fell by 6.5% during this period.
However, most of the time, the rest of the year can provide a reprieve and help investors recoup losses. Don’t expect that to happen this time.
This view is not based solely on restrictive tariffs, political strife in Washington, DC, or the outbreak of war in the Middle East—although none of these are helpful. It’s more about what some of the specs tell us.
Russell 2000: Yield curve raises concerns
For one, the Russell 2000 has been struggling since the end of July, falling more than 12%. The index is now in the red for this year, a stark contrast to the S&P 500, which remains up double digits in 2023. (Even the strength of this index is deceptive. More on that later).
Russell’s struggles could mean all sorts of things for the rest of the market. That’s because members are small, capital-intensive businesses that tend to rely on variable-rate debt to finance their operations.
This makes them extremely sensitive to changes in interest rate policy, which, together with higher labor costs, helps explain the slump. Ultimately, these issues affect businesses of all sizes.
The other concern is the yield curve.
Yes, it has been the other way around for 15 months and the economy has not yet slipped into recession, leading some to theorize that this indicator is no longer the harbinger of doom it once was. However, these arguments ignore that, historically, the period from the first inversion of the yield curve to the occurrence of a recession-induced bear market is typically around 19 to 24 months.
Benefit from favorable stock entry points
This means investors should anticipate the likelihood that the worst is yet to come. Part of this process means keeping some powder dry to take advantage of cheap entry opportunities into highly cyclical stocks sometime around early 2024.
Possible candidates include Dow, Inc. (NYSE: DOW) and LyondellBasell Industries (NYSE: LYB). Even though much of the market has performed well this year, the Dow is down nearly 9% while LyondellBasell is barely treading water. The rest of 2023 will likely be worse for highly cyclical stocks like this.
Both companies produce large quantities of polyethylene. In particular, both companies enjoy a significant cost advantage over their global competitors in this area because they rely on US natural gas for production. The rest of the world uses crude oil, which is far more expensive.
In the past, a good entry point was when the dividend yield reached 6%. After this happened in 2020, the Dow gained more than 34% over a four-month period, while LyondellBasell gained almost 38% over a roughly ten-month period.
Undoubtedly, the severity of the deep technical issues mentioned above has been masked by the resilience of the S&P 500. However, only a handful of companies accounted for the lion’s share of the index’s gains. In fact, the Invesco S&P 500 Equal Weight ETF has fallen significantly over the year.
Even the recent surge could prove to be a smokescreen.
On the face of it, last week’s jobs report supported the argument for a soft landing, thanks to solid employment gains and weaker-than-expected wage growth. But these are lagging indicators.
Bond and equity benchmarks are forward-looking and have been generally more bearish recently. If this trend continues, stocks will find it difficult to maintain their current levels through the end of the year.
The good news is that this cycle will end and a new one will begin, possibly in the first quarter of 2024. Then we could see a decline in overall consumer price index data and the possibility of some easing from the Federal Reserve.
Investors just need to be patient until that time comes.
— By Andrew Graham, Founder and Managing Partner of Jackson Square Capital.
