After achieving a new four-year high on August 21^st, the market ended August with two straight down weeks, the first two-week decline since mid-May. but the total decline has amounted to a minuscule 0.8 percent. No doubt about it, the stock market remains extremely strong!

Investor sentiment is mixed, with the American Association of Individual Investors (AAII) bullish percentage falling significantly in the past week, whereas Investors Intelligence sentiment among newsletter advisors showed 51.0% bulls and only 24.5% bears — the highest absolute bullish percentage and the widest discrepancy (26.5%) between bulls and bears since April. Breaking the sentiment tie between bearish individuals and bullish newsletter advisors is sentiment among Wall Street strategists, which is decidedly bearish. From a contrarian standpoint, with two out of three sentiment surveys bearish, I don’t think a big selloff is in the cards.

I think any stock-market decline in September will be short-lived because, well, the S&P 500 just hit a four-year high. C’mon, how can you call a new four-year high anything but bullish? With the S&P 500 Volatility Index (VIX) recently hitting a five-year low (13.3%) and defensive dividend-paying stocks lagging behind more economically-sensitive non-dividend payers, the “risk-on” trade has the momentum right now. Granted, the VIX has risen more than 25 percent since its August 17th low while the S&P 500 has remained virtually flat, but in the 13 instances when such a wide VIX/SPX divergence has occurred, the market has been higher six months later nine times.

Least-Volatile August in History May Cause September Correction

August 2012 was one of the least volatile stock-market months in history. The Dow Jones Industrials exhibited its narrowest 8-day trading range since at least 1950 and the S&P 500 experienced its second-narrowest 17-day trading range in 40 years (when consolidating near its 52-week high). According to Jason Goepfert of Sentimentrader.com, the only narrower 17-day trading range occurred in October 1995 and the stock market subsequently “headed significantly higher.” On the other hand, in the six instances since 1928 where August’s average daily price movement is the narrowest of the past four months, stocks have declined four of six times during the subsequent month of September. Combined with the fact that “smart money” hedgers in Dow Jones Industrial stock futures are currently “net short” by the third-highest dollar amount in history, and Goepfert sees an elevated risk of a 3% to 8% correction soon. Investing Daily’s Elliott Gue is also calling for a correction.

China’s Stock Market Breaks to New Lows, But U.S. Won’t Follow

After a brief September correction, the U.S. stock market should resume its rise at least into the November 6th U.S. presidential election, hopefully sparing us from following in the stumbling footsteps of China’s stock market — which recently suffered a technical breakdown and fell to 2001 lows. Fortunately, here the in the U.S. the stars are aligning for a bullish short-term combination of sluggish economic growth and additional monetary stimulus. The Federal Reserve’s August 29th Beige Book reported improved economic performance in a number of areas, including consumer spending, real estate construction and prices, energy/mining, and financial services. Second-quarter GDP growth was revised upwards by 20 basis points to an annualized 1.7 percent and the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) registered its first year-over-year positive growth rate since May and its highest positive number since April. I was especially impressed with August same-store retail sales, which were up a very strong 9 percent, easily beating analyst estimates. The CEO of shopping-mall operator Tanger Outlets (NYSE: SKT), for example, recently stated that back-to-school sales have been “terrific.” Since consumer spending is 70 percent of the total U.S. economy, news that it rose by the most in five months is a positive sign.

Bernanke’s Jackson Hole’s Speech Hints at QE3

All in all, the economy is getting slighly better — certainly no worse — and the vast majority of investment strategists and economists believe that another round of monetary stimulus (QE3) is undesirable. Interest rates are already low enough and more easing will just inflate financial assets (e.g., the stock market) without improving the real economy. Yet, based on Fed Chairman Ben Bernanke’s August 31st speech in Jackson Hole Wyoming, more monetary stimulus is probably on the way at the next Fed meeting on September 13th. Although he didn’t explicity advocate more easing, he said three things that suggest QE3 is coming:

1. The past two rounds of quantitative easing have succeeded in increasing GDP by 3 percentage points and created 2 million private-sector jobs;

2. The inflation risks of quantitative easing are “manageable” and “should not rule out the further use” of such policies; and

3. The stagnation in the labor market continues to be a “grave concern.”

Combine the sluggish U.S. labor market with the impending 2013 fiscal cliff as well as the potential contagion from economic weakness in China and the Eurozone, and the Fed may decide to pull the QE3 trigger. If the trigger is pulled, U.S. Treasury bond prices will probably rise and yields fall. In mid-August, the iShares 20+ Year Treasury Bond ETF (NYSE: TLT) briefly fell below $121 in reaction to improving economic data but the bond ETF has rebounded strongly above $127 on rumors of QE3.

China’s downturn is made worse by the government’s paralysis in economic decisionmaking pending the once-a-decade leadership change occuring in October at the Communists’ 18th Party Congress. As for Europe, all eyes are on the European Central Bank’s next policy meeting on September 6th where analysts are expecting President Mario Draghi to announce a new bond-buying program to save Spain and Italy.

The date of September 12th is also important because it is when the German Constitutional Court is expected to rule on a challenge to Germany’s participation in Europe’s bailout fund. A court ruling against Germany’s participation is very unilkely but such a ruling — if it were to occur — would cause a financial panic.

U.S. Presidential Election Could Impact Stock Market

Looking longer-term into 2013, the fate of the stock market could hinge on whether Obama or Romney wins the U.S. presidential election. Although historically the stock market performs better under a Democratic president, this time around an Obama win combined with a partisan and tax-resistant Republican-controlled Congress could result in a fiscal-cliff and debt-ceiling stalemate that results in financial disaster. By contrast, a Republican-controlled Congress would likely give Romney some slack to formulate a deficit-reduction plan during his first year in office and would extend the debt ceiling without a fight. 

In other words, Romney would (ironically) be the deficit-continuation president that would more likely stimulate the U.S. economy and keep it out of recession, whereas Obama would be forced by Congress to be a fiscal-retraction president that pushes the U.S. back into recession. This 2012-specific analysis meshes very well with historical precedent; according to Citigroup research, the stock market performs much better when a challenger wins the presidential election than when the incumbent wins:

Presidential Election Outcomes and Stock Market Returns

Most of the challenger’s historical outperformance occurs, however, in the third and fourth years of the presidential term (most likely due to a two-termer’s “lame duck” status). Consequently, this historical phenomenon isn’t really applicable to the upcoming fiscal-cliff problem in 2013 (Year 1).

If Romney wins, best industry sectors will be utilities (XLU), financials (XLF), health care (XLV), defense (ITA), and energy (XLE). If Obama wins, I would look at alternative energy (PBW), technology (XLK), entertainment (PEJ), and generic drugs (TEVA, RDY, WPI, MYL, PRX).