So far, so good. That's perhaps the best assessment of the stock market in 2023 at this point. All the major indexes are in positive territory. The S&P 500 is on track to deliver its fourth double-digit percentage gain in the last five years.
But don't rest too easily. There are three potential dangers for the stock market in September. Here's what they are -- and how investors can prepare.
Image source: Getty Images.
1. Frothy valuations
It's possible that the stock market could become a victim of its own success. The impressive performance this year for the S&P 500 has arguably led to a historically high valuation for the index.
One of the best ways to assess the valuation of the S&P 500 is the cyclically adjusted price-to-earnings (CAPE) ratio, also known as the Shiller PE ratio. Popularized by Yale professor Robert Shiller, this ratio compares the index's current share price to its real (inflation-adjusted) earnings per share averaged over a 10-year period.
So, how does the Shiller PE ratio for the S&P 500 look these days? In a word, frothy.
S&P 500 Shiller CAPE Ratio data by YCharts. CAPE Ratio = cyclically adjusted price-to-earnings (CAPE) ratio.
To be sure, a steep valuation doesn't necessarily mean the stock market will plunge in September. However, the chart above shows that the S&P 500 doesn't tend to remain above its current valuation for too long before a correction ensues.
2. Macroeconomic headwinds
Macroeconomic headwinds present another potential risk for stocks this month. I don't want to overstate this threat, though. The U.S. economy doesn't look too bad right now. That's especially the case on the jobs front, with the unemployment rate at a low 3.5%.
However, inflation did accelerate in July after months of consecutive declines. The Federal Reserve hasn't ruled out more interest rate hikes.
Perhaps the biggest worry is China. For years, the country consistently delivered robust economic growth. Now, though, China's economy appears to be faltering.
Unfortunately, what happens in China won't stay in China. The country boasts the world's second-largest economy. It's a major trading partner with the U.S. and Europe. If China's problems worsen in the near future, the U.S. stock market could feel the pain.
3. The "September effect"
Finally, we also must consider the "September effect." Historically, September has, on average, been the worst-performing month for stocks. And this pattern goes back almost 100 years.
We're not talking about huge pullbacks in most years. Going back to 1928, the S&P 500's average decline in September is only 1.1%.
There are several theories as to why the September effect exists. Perhaps the strongest argument is that institutional investors could prefer to lock in profits near the end of the third quarter as the end of the year approaches. However, this idea hasn't been proven.
How to prepare
Should investors dump all their stocks because of these three dangers? No. The stock market can continue to move higher for quite a while despite having a steep valuation. Those macroeconomic headwinds might not be problematic. The September effect doesn't always happen.
But what if the stock market really is headed for a turbulent month? There are two things you can do to prepare, just in case.
First, build up a solid cash stockpile if you don't already have one. Market pullbacks can create great buying opportunities. By the way, you won't be alone by taking this action. Warren Buffett, one of the greatest investors of all time, is doing it for Berkshire Hathaway.
Second, focus heavily on valuation versus growth prospects with any stock you buy. Again, that's what Buffett does. Although he was a net seller of stocks in the second quarter of 2023, he still bought a few stocks for Berkshire's portfolio. All of them were attractively valued.
Maybe September will be a great month for the stock market; maybe it won't. The good news with building a cash stockpile and focusing on valuation is that you can make plenty of money in the long run either way.
