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After a rocky start to August, the S&P 500 has all but clawed back its losses.
However, LPL Financial's Chief Equity Strategist Jeffrey Buchbinder warns that more bumpiness could lie ahead as summer comes to an end.
Buchbinder and his team pointed out in a recent note that September is historically the worst month for the S&P 500. Since 1950, the S&P 500 has dropped 0.5% on average in September. And this phenomenon has been especially pronounced in the last five years, falling 3.2% on average.
And Buchbinder isn't convinced this time around will be much better.
"Although we welcome the recent rebound and more upbeat macroeconomic data, market breadth on the latest bounce has been underwhelming, and there isn't quite enough technical evidence to make the case that the lows of this pullback have been set," Buchbinder wrote.
Instead of prematurely celebrating a market rebound, Buchbinder is keeping his eye out for these three indicators of a turnaround.
First, he's looking for more clarity from the Fed regarding rate cuts.
After last month's disappointing jobs report, markets have priced in a rate cut in September, but there's ongoing debate over just how much the Fed will cut.
"Summer months are notoriously volatile due to the lack of liquidity in markets, so we would expect rate cut expectations to continue to oscillate throughout the third quarter," Buchbinder wrote.
Buchbinder believes that a 50-basis-point cut in September is overly aggressive but not off the table if the August jobs report is weak. He predicts that the Fed will cut three times starting in September. Of course, this schedule could change depending on new economic data. The Fed's Jackson Hole meeting later this week is one opportunity for clearer signaling on a rate cut schedule.
Buchbinder is also looking for more market breadth. While the August correction sparked some rotation out of Big Tech, Buchbinder is waiting for "more stocks participating in the market advance."
One gauge of market breadth is the percentage of oversold stocks, or stocks that have declined in price and are likely to rebound. In Buchbinder's view, there's a risk of additional selling pressure as he believes oversold conditions haven't hit their extremes yet.
The percentage of oversold stocks, according to the Relative Strength Index, or RSI, is currently hovering around 12%, which is below historic market bottoms of 20% or greater. The RSI measures the momentum of a stock price, and a reading of 30 or below typically indicates an oversold stock.
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The market should broaden after an RSI spike as investors start scooping up previously overlooked stocks, but Buchbinder hasn't seen that inflection point yet.
Lastly, stability in currency markets is another indicator of a market turnaround. The unwinding yen carry trade caused a meltdown in markets across the world. Investors had been borrowing the ultra-low interest rate yen and investing in assets with a higher return elsewhere. When the Bank of Japan increased interest rates in July, strengthening the yen as a result, investors rapidly closed out of their positions and sent volatility spiking.
Buchbinder estimates that 75% of carry trades have been closed, but if the yen appreciates further, more financial instability could ensue. Buchbinder is looking for the 200-day moving average for the dollar/yen to reach 152 to signal reduced carry trade volatility. He sees a close below 141 as a sign that there will be more unwinding to come.
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Buchbinder is neutral on equities overall as the market remains in limbo for the next couple of months.
He recommends that investors withdraw money from cash balances and funnel it into fixed-income investments as a buffer against stock market instability, as there is a chance that economic conditions will worsen.
However, not all fixed income assets are created equally, Buchbinder cautions. Avoid corporate credit, as spreads are very tight. That means that investors who purchase riskier corporate debt aren't getting that much more return than they would be from risk-free government bonds.
"We don't think we're getting compensated to take on credit risk at this point," said Buchbinder. "We would prefer to use our risk budget in more attractive fixed-income areas."
Instead, Buchbinder recommends preferred securities, which share characteristics of both stocks and bonds. Preferred securities get higher divident distribtions than common stock, making them a more reliable source of income. Now is a particularly good time to invest in preferred securities according to Buchbinder, as many financial institutions issue these assets and the overall sector is poised to benefit from impending rate cuts.
For investors interested in increasing their allocations to preferred securities, funds such as the Invesco Preferred ETF (PGX), the iShares Preferred and Income Securities ETF (PFF), and the John Hancock Preferred Income ETF (JHPI) offer exposure to this asset class.
