By David Randall
NEW YORK (Reuters) -The 10.7% rally in the S&P 500 from its June lows is stumbling as it runs into what has historically been the toughest month for the U.S. stock market, sparking nerves among some fund managers of a broad sell-off in September.
The S&P has been in a bear market since plummeting early this year as investors priced in the expectation of aggressive Federal Reserve interest rate hikes, but the index has rallied strongly since June, regaining half its losses for the year.
That rebound has been fueled by a combination of strong earnings from bellwether companies and signs that inflation might have peaked, potentially allowing the Fed to slow rate hikes.
But as investors and traders return from summer holidays, some are nervous about a bumpier ride in September, due to seasonal concerns and nervousness about the Fed's pace of hikes and their economic impact.
The S&P 500 fell nearly 3.4% Friday after Fed Chair Jerome Powell reiterated the central bank's commitment to taming inflation despite a possible recession.
"These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain," Powell said in a closely watched speech in Jackson Hole, Wyoming.
September typically is a down month for the stock market because fund managers tend to sell underperforming positions as the end of the third quarter approaches, according to the Stock Trader's Almanac.
"We've had a breathtaking run and I wouldn't be shocked if the market takes a hit here," said Jack Janasiewicz, lead portfolio strategist at Natixis Investment Management Solutions.
The S&P 500 could fall as much as 10% in September as investors price in the likelihood that the Fed will not start to cut rates as early as some had hoped, Janasiewicz said.
September has been the worst month for the S&P 500 since 1945, with the index advancing only 44% of the time, the least of any month, according to CFRA data. The S&P 500 has posted an average loss of 0.6% in September, the worst for any month.
The index is down 14.8% year to date and has been in a bear market, hitting its lowest level in June since December 2020 after the Fed announced its largest rate hike since 1994.
Chief among the reasons for the gloomy outlook is a belief that the Fed will continue hiking rates and keep them above neutral longer than markets had anticipated as recently as a week ago, weighing on consumer demand and the housing market.
Nearly half of market participants now expect the Fed funds rate to end the year above 3.7% by the end of the year, up from 40% a week ago, according to the CME FedWatch tool. [/FEDWATCH] The fed funds rate is currently between 2.25 and 2.5%.
The Sept. 20-21 FOMC meeting will also likely drive volatility during the month, prompting the S&P 500 to fall near its June lows, said Sam Stovall, chief investment strategist at CFRA. Ahead of that will be critical economic data, such as a reading on consumer prices that will give investors more insight into whether inflation has peaked.
The strong rally since June, however, suggests the index will continue to rebound through December, Stovall said.
"While we might end up retesting the June low, history says that we will not set a new low," he said.
While fund managers as a whole remain bearish, the ratio of bulls to bears has improved since July, reducing the likelihood of outsized gains in the months ahead, according to Bank of America survey released Aug. 16. The bank's clients were net sellers of U.S. equities last week for the first time in eight weeks, suggesting that investors are growing more defensive, the bank said.
At the same time, the use of leverage by hedge funds - a proxy for their willingness to take risk - has stabilized since June and is near the lowest level since March 2020, according to Goldman Sachs.
Investors may rotate into technology and other growth stocks that can take market share despite an economic slowdown, said Tiffany Wade, senior portfolio manager at Columbia Threadneedle Investments, who is overweight mega-cap stocks like Amazon.com Inc and Microsoft Corp.
"We expect the pullback will start with some of the riskier names that have run up a lot since June," she said.
(Reporting by David Randall; editing by Megan Davies and Chizu Nomiyama and Richard Chang)