Predicting the future direction of the stock market is a damned if you do, damned if you don’t proposition.

That’s why some analysts avoid it altogether. They say you can safely ignore the ups and downs of an index like the S&P 500.

Others say that predicting market direction is a waste of energy. Just buy the right companies, and it won’t matter.

Those answers wouldn’t satisfy most subscribers to my Bauman Letter. People constantly ask me what I think the market is going to do.

They’re right to ask.

There are two problems with the “ignore the index” attitude.

One is that it flies in the face of the well-known recommendation to diversify. Sure, you can own tomorrow’s hottest stocks … but you don’t want to concentrate everything there.

Every sensible investor also wants to hold steady stocks, like dividend-paying real estate investment trusts or closed-end funds that move up and down with the index. You might even want to buy them on the dip to increase your yield on cost.

The other is that it ignores human nature. Big moves at the index level trigger emotions that can lead to trading mistakes.

For those reasons, I offer my subscribers my educated guesses about where the market is likely to go in the short term. Even if we’re only halfway through a long-term secular bull market — which is what I believe — it’s worth trying to get ahead of short-term fluctuations.

And on that score, I wouldn’t be surprised if the final three months of 2021 are the bumpiest since the pandemic crashed the market in early 2020.

September Blues

Last month’s stock market return was the worst since March 2020:

monthly S&P 500 performance

(Click here to view larger image.)

When in the midst of a pullback like that, the tendency in the financial press is to focus on an endless stream of short-term catalysts.

First we had the Evergrande debt default. Then came the Federal Reserve taper talk. The August employment figures were a big miss. Inflation is running rampant. Stimulus money has all been spent. Congress is dysfunctional. And over it all hangs the Delta variant of COVID-19.

True to form, the first week of October brings a new crisis du jour: rising oil prices. Even though the price of a barrel of West Texas Intermediate has been rising steadily since spring of 2020, it recently broke out above medium-term resistance, surpassing levels last seen in 2018. The next stop, purportedly, is over $100 a barrel:

crude oil price chart

(Click here to view larger image.)

All that negative news has had a predictable impact on sentiment.

After peaking in late spring, investor expectations of a positive return over the next 12 month have fallen sharply. Some 65% still think the index will eke out a positive return over the next 12 months, but that’s way off recent highs:

expectations of stock market return

(Click here to view larger image.)

Stability Breeds Instability

One of the most important lessons I’ve learned from economic and financial history is that periods of stability create the conditions for the opposite.

We can see this via two trends in the stock market in 2021. One is obvious. The other is lesser known, but arguably more important to short-term price moves.

The first trend is high and rising valuations. The cyclically adjusted price-to-earnings (CAPE) ratio today is 37.1. That’s the second-highest measure ever. It’s more than twice as high as the long-term average of 17.2.

When valuations get that far ahead of themselves, investors get nervous. Like a high-strung thoroughbred, any provocation can set them prancing and bucking.

When you step back and look at recent investor behavior, it’s clear that the mini-crises that dominated the 24-hour news cycle were just expressions of that underlying high-valuation angst.

Many investors aren’t even aware of the second trend. But it’s become increasingly important all summer … and it’s turning ominous.

By some estimates, Wall Street’s computerized high-frequency quant traders make over 60% of trades. That gives them enormous power to move the market.

An increasingly popular quant strategy uses volatility to accumulate steady gains.

When “realized” market volatility — the movement of real prices in the recent past — is low, computer traders accumulate short-term call options on stocks. Statistically, it’s a safe bet.

When volatility is low for an extended period — as in the green rectangle in the following chart — the strategies also buy the stocks underlying these options as a hedge:

CBOE volatility index chart

(Click here to view larger image.)

When the market is trending upward with little volatility — as it did for most of the summer — this “vol control” strategy reinforces that trend. Low realized volatility encourages computers to buy more call options, which prompts more purchases of the underlying stock … which keeps prices rising.

But it can also do exactly the opposite.

If options pricing suggests increased future volatility, the “vol control” computers stop buying calls and their underlying stocks. Given the volume of those trades, that can pull the rug out from under the market.

There are strong signs that this little-known part of the market has switched from low volatility to high volatility strategies. When that happens, these powerful quant systems go from keeping the market stable to making it prone to sudden corrections.

Perspective Is Everything

I obviously can’t say with certainty that the last quarter of 2021 will be volatile and tend to the downside. But, in the context of extended valuations, plus a reversal in the “vol control” universe, a weak earnings season, rising 10-year Treasury yields and a spike in energy prices could lead to a sharp drop.

This is where that historical perspective is so important.

We’ve seen this game before.

In the second half of 2015, stocks pulled back sharply on concerns about the Chinese economy.

In the fourth quarter of 2018, the stock market experienced its largest short-term drop since the great financial crisis after Federal Reserve Chairman Jerome Powell made some injudicious comments about raising interest rates:

S&p 500 chart

(Click here to view larger image.)

The point is that even if stocks do pullback, they eventually resume their upward march. And the one correction I didn’t highlight proves the point … the Corona crash in first quarter last year.

So let’s say you agree with my prediction that we’re headed for a volatile fourth quarter with the potential for a big pullback. Here are five strategies you can adopt:

  1. Increase your cash allocation. Cash is as much a part of your portfolio as any other asset. Don’t be afraid to let money sit on the sidelines for the next quarter or so.
  2. Take profits where you can. If you are up on a couple of investments that might be vulnerable to a pullback, sell some stock now. As long as you wait 31 days to rebuy the stock at a lower price, you can do so and decrease your overall cost basis if the market does turn south before the end of the year.
  3. Harvest tax losses. There are certainly plenty of opportunities to do that in 2021. If you’re trading outside a retirement account, consider closing out some losers to offset gains you’ve made elsewhere.
  4. Buy the dip. The chart above shows that dip buying can be extremely lucrative. History shows that markets fall, but they bounce back. Take advantage of that.
  5. Above all, stay the course. Particularly if your investments are in a retirement account, don’t panic sell if the market does pullback. Every time you feel like doing so, take a look at the chart above to remind yourself what a mistake that would be!

And remember, stay smart and tough.

Kind regards,

Ted Bauman
Editor, The Bauman Letter