Get ready for some spooky stock trading in October

After a bright and cheerful summer, the chill of autumn has hit Wall Street. The Dow Jones industrials lost 0.5 percent in September, trimming its third-quarter gain to 2.1 percent. The S&P 500 was unchanged for the month. For the year, the Dow is up 5.1 percent.

On a technical basis, stocks are in stasis as the future looks increasingly binary. After surging in July and August, the Dow is settling back near 18,000 -- a level first reached in late 2014. One gets the feeling we’re headed for an epic upside breakout -- or a heartbreaking sell-off.

Heading into October, historically a month of seasonal weakness as negative headwinds loom, the odds of the downside scenario are growing more likely.

Last week saw increased volatility and spooky 2008-style headlines surrounding the situation with Deutsche Bank (DB) on liquidity concerns. Hedge funds are reportedly pulling excess cash out of the institution as counterparties balk at rising default risks. Deutsche Bank shares got a reprieve on Friday on unsubstantiated rumors the U.S. government would lower its settlement with the bank related to bad mortgage backed securities to $5.4 billion from the $14 billion initially floated. 

The stock gained 14 percent as a result, and Wall Street rallied smartly to end September on a up note.

The trouble is, the rumor remains unconfirmed, and structural issues remain for Deutsche Bank, including a weak eurozone economy, risks from Brexit and lingering bad debts.

With confidence fragile, withdrawals of deposits and trade collateral could quickly worsen Deutsche Bank’s liquidity position -- as it did earlier in the year before a surge of fresh stimulus from the European Central Bank (including cutting interest rates into negative territory).

Moreover, while Deutsche Bank shares recovered, other markets weren’t as impressed. Credit default swaps against the bank, which pay out in the case of default and rallied hard on Thursday, didn’t really suffer much of a decline. German government bonds remain well bid as well, a sign of ongoing demand for safe havens.  

And stock investors will also confront some hard fundamentals in October.

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U.S. GDP growth has flat-lined for the last three quarters (chart above). And the now-completed third quarter isn’t looking so hot either: According to the Atlanta Fed’s GDPNow estimate, the period’s growth has been cut from 3.8 percent back in early August to just 2.4 percent now. A steady stream of disappointing economic data is to blame for the markdown, including construction spending, personal spending and manufacturing activity.

What about corporate earnings? Don’t forget we’re in the midst of a profitability recession, with S&P 500 earnings now expected to decline for six consecutive quarters through the third quarter, thanks to a combination of still-low energy prices, weak economies in Asia and Europe and the drag on corporate earning from a strengthened U.S. dollar.

According to FactSet, earnings are expected to decline 2.1 percent for the third quarter to cap the worst run for earnings growth since the financial crisis. Energy sector earnings are expected to decline more than 50 percent from the same period last year. The third-quarter reporting season will kick off on Oct. 10 when aluminum maker Alcoa (AA) reports.

Other headwinds: The specter of a Federal Reserve interest rate hike in December, the looming U.S. presidential election and negotiating and implementing the tentative oil-production freeze OPEC has preliminarily agreed to.

Moreover, the market’s long engagement with ultracheap monetary policy has eroded the benefit of diversification as well, with correlations between individual stocks and between stocks and the bond market tightening up. A few weeks ago, stocks and long-term government bonds were falling in unison on worries that “risk parity” trades were breaking down.

All this comes at a time when stock valuations are extended: The S&P 500 is trading at 16.6 times forward earnings -- above the 10-year average of 14.3 -- and investors are showing signs of complacency.

My advice? Get ready for some spooky trading in October. 

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.