Brace for the Perfect Storm: Rate Cuts and a Slow September

Key Points

• The market is facing what has been a historically slow September, but it is also experiencing the opposite rate-cut effect that investors expect.
• Money is shifting in a way that confirms a flight to safety behavior toward bonds and gold, setting up the scene for potential downside. 
• After leaving the high-flying technology sector, mega investors like Stanley Druckenmiller find enough reason to invest in bonds and small-cap stocks.

Like its participants, the market goes through cycles, some of which are predictable on a fundamental and statistical basis. Today, the S&P 500 is experiencing a headwind caused by two factors: historically slow stocks in September and the potential effects of the Federal Reserve (the Fed) cutting interest rates this week.

According to the CME's FedWatch tool, there is now a 63% probability that the Fed will cut rates by 50 basis points (bps), with a 37% chance of a 25bps cut. When interest rates come down, financial assets like stocks and bonds tend to do well, only as long as other economic indicators are not lined up against the momentum these rate cuts could cause.

Today, investors will find out why interest rate cuts won't be as good for the stock market this time around as everyone thinks, especially as the statistically significant measures in the economy are flashing warning signs for essentially all industries in the market today. Here's where money has been going in the face of these slowing indicators today.

Key Market Drivers Slow Down, Prompting Money Shifts Ahead of Next Quarter

Investors and traders are forward-looking, and all are looking to predict the same thing: the United States' gross domestic product (GDP). A big part of GDP is made up of the manufacturing sector, which has been on a 22-month contraction, as seen within the ISM manufacturing PMI index.

Judging by how some manufacturing stocks have performed lately, the market is trying to warn investors. A stock like Caterpillar Inc. NYSE: CAT trades at 92% of its 52-week high, and others like Deere & Co. NYSE: DE trade at similar 95% highs, which sends a deeper message to the market.

The message is that those companies with enough international sales exposure might escape the historically slow September month and the potential sell-off coming from Fed interest rate cuts. Another warning sign is that dollar-quoted commodities like gold make a new all-time high while oil struggles to make it past $75 a barrel.

Gold is saying the dollar is going to weaken and investors will attempt a flight to safety, while oil is trying to say that business activity will continue to contract. Why would business activity continue to contract? The PMI index contraction is one cause, but here's a deeper one.

The United States yield curve (ten-year yields minus two-year yields) has now returned to positive and is steepening quickly. Every time the yield curve returns to positive from an inversion, the economy starts to dry up in terms of liquidity and activity.

Knowing that the commodities market is sending warning signs around a potential slowdown, and other indicators like unemployment are rising, investors should be on the lookout to hedge out the risks that could come from this perfect storm.

Where Markets Are Seeking Safety Amid the Upcoming Financial Storm

Following the price action of gold in the SPDR Gold Shares NYSEARCA: GLD as it makes a new all-time high can be taken as a sign of flight to safety. However, other asset classes outside precious metals tend to attract capital when the broader market adopts this attitude.

Bonds are a good example, as investors like Stanley Druckenmiller have recently sold out of the technology sector. NVIDIA Co. NASDAQ: NVDA will instead invest in the iShares 20+ Year Bond ETF NASDAQ: TLT.

That ETF is now trading at a new 52-week high as investors flock to bonds for perceived safety. The commitment of traders (CoT) report confirms the market’s current sentiment and expectations, measuring the level of inventory held in S&P 500 futures contracts.

The market can now be considered “too long,” as non-commercial participants (like institutional investors and fund managers) are as long on the market as they were in late 2007 and 2019. This means inventory is relatively tapped out and running out of new potential buyers.

As the S&P 500 gives up momentum during this slow September, alongside the potential disappointment from the Fed’s interest rate cuts, it sets up a risk that far outweighs the reward when it comes to the market’s next move until the end of the year.

If this downside is realized for the broader market, Tom Lee from Fundstrat has recommended that investors consider small-cap stocks for the coming quarters. Small businesses, in general, will likely benefit from the more flexible financing rates and ample liquidity created by the Fed.