Why the S&P 500 could soon lose 10% before you even realize what just happened

Brian Sozzi
Editor-at-Large

The stage is set for a decent-sized pullback in stocks this month.

Let’s remember, however, that September often isn’t grand for stocks even when there isn’t a trade war ripping through global asset markets. Since 1950, September has been the worst month for the S&P 500 (^GSPC), dropping an average of 0.5%, according to data crunched by LPL Financial. Over the past 10 years though, the S&P 500 has averaged a 0.9% gain powered by a post Great Recession profit recovery in Corporate America and supportive interest rate policy from the Federal Reserve.

But given the real effects of the U.S.-China trade war starting to take root in economic data across the world, this September could be worse than the average dating back to 1950. Stock valuations must adjust to what could be the new norm on trade, at least until the U.S. heads to the polls in 2020 to pick a president.

“August was a burst of volatility for most investors, and we expect that to continue in September,” said LPL Financial senior market strategist Ryan Detrick.

Diamond Hill Capital Management strategist John Mcclain was more blunt.

“We are certainly a bit on edge here. Volatility is back. Resistance levels don’t really matter at this point, it’s all about the rhetoric on trade. I think if we don’t see a resolution fairly soon, you are going to get to a point of no return in terms of the amount of damage inflicted to the U.S. economy,” Mcclain said on Yahoo Finance’s The First Trade.

Encouraging, but not really.

Be cautious

Morgan Stanley’s Mike Wilson — who has mostly been bearish on stocks the last year — nicely lays out the case for investors to approach September and year end with caution.

For starters, the global manufacturing recession is getting next level worse. Wilson notes that 70% of purchasing managing indexes (PMIs) — a key gauge on the manufacturing sector’s health — globally are below the 50 level that separates contraction from expansion. Wilson says he hasn’t seen these types of readings since the 2008-9 financial crisis.

To that end, the Institute for Supply Management said Tuesday its PMI index dove to 49.1 in August. That was below the important 50 level and much worse than market expectations. It also marked the first time in contraction zone since 2016. New orders within the PMI report dropped to a seven-year low.

Besides weakening manufacturing conditions (insert trade war aftershocks), which is creating downside momentum to GDP readings from Germany to the U.S., Wilson says Wall Street profit estimates are beginning to come under pressure. By extension, stock prices have to adjust for this one.

S&P 500 profit estimates for the third quarter call for a 2.7% decline, worse than the 0.5% decline seen in the first half of the year. Wilson notes for the S&P 500, profits are seen diving 7.4% in the third quarter compared to a 5% decline in the first six months of the year.

Wilson expects the S&P 500 to drop about 10% to 2,700 by year end. He recommends investors stay positioned in defensive stocks such as consumer staples and utilities.

Chipping away at investor confidence

Many pros Yahoo Finance have talked with continue to be upbeat on stocks. They collectively point to the resilient U.S. consumer, steady job gains and a Federal Reserve that looks set to pump the system with more insurance rate cuts.

“While there is plenty to worry about, do not un­derestimate the powerful influence of aggressive policy stimulus underlying this stock market. Perhaps, as shown in the enclosed note, record low bond yields, accelerating growth in the money supply, and outsized fiscal support may just prove to be the healing ointment for contemporary concerns,” says veteran strategist Jim Paulsen over at The Leuthold Group.

Perhaps. But it’s growing ever harder to completely ignore weakening global economic data and a trade war with China that is chipping away at investor confidence (and corporate profits). The market at some point soon has to price these factors in, possibly to the tune of a 10% washout.

Brian Sozzi is an editor-at-large and co-host of The First Trade at Yahoo Finance. Follow him on Twitter @BrianSozzi