History Says September Will Be Rough for Stocks. How to Invest for an October Turnaround.

When the stock market re-opens for trading on Tuesday after the Labor Day break, it could be the start of a rough month for stocks. But October should be better and the outlook remains positive for growth sectors of the economy.

Those views come from James Paulsen, chief investment strategist at the Leuthold Group. In a report out Friday, he argued that stock returns in September are likely to be rough, but that things should pick up in October. He recommended sticking with growth stocks that have done well in this market and should continue to outperform.

“If you’re nervous that the recovery is ending, I’d be in defensive stocks and cash,” he said in an interview with Barron’s. “But until then, ‘new-era’ growth stocks will lead.”

Over the last 50 years, Paulsen said, the direction of the stock market, bond yields, and M2 Money Supply have all had “significant bearing” on September stock returns. Two of those indicators are now pointing south.

The S&P 500 has gained just 3.5% in the last six months (not including a recent bounce taking it to 5%). That’s a below-average performance for such periods leading to September since 1947. And that suggests “a below-average September is on the horizon,” Paulsen wrote in his report.

Another negative indicator is bond yields. Rising yields over the prior six months has been a bullish indicator for September stock returns, he wrote. But bond yields have plunged in recent months, a bad omen for September.

The one bright spot is M2 Money Supply, or the amount of money circulating in the economy. Money supply is like the pulse rate of the economy. When it’s rising, it implies more borrowing, spending, and signs of inflation—all things the stock market likes to see (within reason).

Historically, when money supply increased at an above-average pace, the stock market has responded favorably, Paulsen noted. And M2 has been above average over the last six months. Indeed, Paulsen said, the growth rate in M2 in the last six months have been above average relative to every six month period leading up to September since 1947.

September, of course, has a bad reputation for stock returns. Since 1950, it has been the worst month for the S&P 500, which has fallen an average of 0.5% during the month, Ryan Detrick, senior market strategist for LPL Financial, noted in a blog post. September’s record has been a bit better recently: Over the past 10 years, the S&P 500 has averaged a 0.9% gain in September.

Paulsen pointed out that market returns in September have been slightly negative since 1947. Thus, while M2 appears accommodating, returns “may be challenged” by the paths of both the S&P 500 and bond yields, Paulsen wrote.

Surprisingly, October should be better. That might seem counterintuitive, given that October has a dismal reputation for stocks. Two of the biggest market crashes (in 1929 and 1987) occurred in October. And according to Wall Street lore, there is an “October effect” of stocks declining more than average in the month.

But that appears to be folklore. Until 1970, the average market return in October was negative, Paulsen wrote, and “when paired with September, the two represented the worst months of the year.” But starting in 1970, the average annualized gain in October has been 11.6%, making it the fourth best month of the year.

What should investors make of these seasonal effects? If one were to subject them to a rigorous statistical analysis, the answer would probably be not much. Moreover, we are in a volatile political climate with an unpredictable president who can move the markets with a tweet. There’s no historical precedent for that.

Nonetheless, Paulsen argues that this isn’t the time to get defensive—yet. Defensive sectors like utilities, consumer staples, and real estate, “look overbought and overvalued,” he said. Investors should use market dips as opportunities to buy relatively cheap cyclical sectors like industrials, materials, and financials, along with emerging markets.

He also recommends “popularity” stocks: tech, communication services, and consumer discretionary stocks that should maintain their leadership as long as the bull market lasts.

Paulsen’s rationale is that business investment is increasingly bifurcating between old- and new-era sectors. New-era investment is spending on “information-technology processing equipment and intellectual property products.” Old-era investment is non-residential investment in everything else, Paulsen said.

New-era investment now comprises 54% of total business spending, up from about 40% at the start of the economic recovery, Paulsen said. The trend shows no signs of abating, and even if the economy contracts, new-era investment is likely to keep rising (while investment in old-economy sectors would probably decline).

“In a world of 1.5% Treasury yields, you need to have something with a persistent growth rate that’s two to three times that of the economy overall,” he says. “I worry about valuation, no doubt, but valuation won’t be the cause of a market downturn. Until the recovery is over, this theme will lead, regardless of valuation.”