Making Sense Of The August Markets

Includes: IWM, SPY, VGK
by: Kevin Flynn, CFA

There are three broad currents for the markets to deal with during the remainder of August. Due to vacations and low participation, August tends to be a trader's market that can detach from the real economy more than any other month. Take note as well that the trader's August actually runs until shortly after Labor Day weekend.

The current move upward in the market has been easy enough to understand, despite media attempts to dramatize it and the usual book-talking from traders and managers. This is the monthly light week for data, and the rule of thumb for the light week that happens once every month is that the markets keep going in whatever direction they left off with at the end of the previous week. A dramatic surprise will throw it off, as it can any week, but we really don't get that many that come out of the blue - usually surprises come from unexpected results from scheduled events.

You can look for this trend to wear out by next Tuesday, when the July retail sales report is due. Not that we're necessarily predicting a lemon, but the economic calendar gets busy from that point on. Markets won't simply keep floating up on low volume anymore, but go back to reacting to actual reports. The bar should be higher by then.

As we move into the end of the month, there should be another calendar current, in this case an attempt to revive prices again. We call it the "silly season," a name inspired by the professional golf calendar. It usually lasts a week or two and runs from somewhere in late August until after Labor Day. We had ourselves a nice little silly-season rally in August of 2008, for example, despite being smack in the middle of a recession and warning signs everywhere that the financial system was about to crack. The Fed was going to save us, you see, which sounds a lot like this year's thinking (and every other late August period looking for an excuse to go higher).

The third current is that mid-August sell-offs are common. With the July data unlikely to impress next week and a clearly weakening corporate earnings environment, the odds look fairly good for a repetition. The principal chance for avoiding it this year might have been the low expectations that we had only ten days ago, but bullish sentiment has risen sharply since then, perhaps excessively, as Mark Hulbert warned.

The wild card in all of this - and this year it's something not to be taken lightly - is what may come out of Europe. It's quite unusual for anything to happen in the European August, as that is the premier family vacation time of the year and most leaders are indeed off on holiday. A low-volume, unsuspecting market is arguably an excellent time for European Central Bank (ECB) president Mario Draghi to come in with guns blazing and scare the daylights out of those short any European instrument, be it stocks, bonds or the currency.

Whether or not he does it is the question of the month, even the year. Our belief remains that only a crisis will pull the ever-widening European rift back together again in concerted action, but it's possible that Draghi could pull off a surprise coup and present leaders with a fait accompli when they come back from vacation. Some may indeed prefer just such an outcome, allowing the ECB to take the heat while they bluster and huff to unhappy domestic voters.

There is a dual paradox in all of this. The first is that as the markets rise on the hope for action, they simultaneously remove the case for it. With the recent rallies in equities and bond yields, both Mr. Bernanke and Mr. Draghi have less of a market case for launching new accommodation measures. A typical August would leave the major indices fairly close to where they are now, first selling off and then rallying again as the silly season takes hold and the promise of more central bank meetings draws near. It will be very difficult for the Fed to launch new programs next month if the S&P is still sitting near the levels it's at now.

It isn't unusual for markets to do the work of the central banks; indeed the latter often count on it. In the case of Europe, though, central bank action simply isn't going to be enough to repair a fractured system. The ECB may in the end find a pretext for buying sovereign bonds, but monetary policy is best suited for treating monetary problems. Bond-buying isn't going to solve the larger problem of masses of essentially unrepayable loans that grow larger with every month of the deepening recession.

Nor would it solve the problem of needed competitive adjustment, as many of the EU countries require competitive restructuring. It could come quickly from a devalued currency, slowly from a restructured economic environment, or somewhere in between from a combination of the two. Yet a devalued currency, alone or in combination, seems very unlikely to come about without a major crisis occurring first, while a restructured economic environment leading to more competitive European products will happen too slowly to stop the current recession from worsening significantly.

The second paradox is that despite the ECB's inability to fix either the European economy or its competitive position - theoretically it could devalue the euro, but that would surely cause a breakup of the currency zone - the financial markets may very well act as if it can, in particular the equity markets. Markets have often rallied right to the edge of the cliff on the prospect of more central bank easing - and then fallen off.

Similarly, the Fed can do little more either. What the U.S. needs most right now is a recovering global economy, above all for Europe to get better, something that is out of the Fed's hands. US data would have to be quite weak at this point for the Fed to act independently of Europe's problems, leading to a strong sell-off first before any rally (no sell-off, no Fed action). But Fed policy would have little effect on the lack of demand plaguing the US, and would likely be followed by data that mostly grew weaker before it got stronger.

The fiscal cliff, a currency too expensive for the troubled EU countries (though a gift for Germany), the severe Midwestern drought, China's property bubble, the need for debt restructuring and competitive restructuring in Europe, along with an end to its austerity programs - none of these can be solved by central bank action. But the markets would nevertheless pretend otherwise, at least for a time. Therein lies the danger for both money managers and investors: Ignore the rally and you may lose your clients; invest with it and you may lose your capital. Crashes come only from a height, and not even the traders get out in time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.