Dow faces 'dangerous' summer as investors relax at the beach

The stock market, which has powered to all-time highs this summer despite pricey stocks, Washington gridlock and sluggish economic growth in the U.S. – has a new hurdle to overcome: the calendar.

As July flips to August, the Dow Jones industrial average enters a two-month stretch known for stock-market slumps.

In the past 20 years, August is the worse month for the Dow's performance, with an average drop of 1.4%. And September hasn’t fared much better, posting average losses of nearly 1%, which is the third-worst monthly ranking. If you go back 100 years, September is the Dow’s worst month of the year.

This is known as "seasonal" weakness, a quirk of the market that tends to keep happening.

“There may be some self-fulfilling bias as investors are more likely to sell during these months since it’s a common belief that these are ‘dangerous’ months,” says Andrew Adams, a market strategist at Raymond James Financial, headquartered in St. Petersburg, Fla.

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The Dow, which suffered mild losses last August and September, has hit major turbulence those two months a few times since the bull market began after the 2008-09 financial crisis.

In 2015, the Dow swooned 6.6% in August and 1.5% in September amid fears that the economy in China, the world’s second-largest, was on the verge of a major slowdown after Beijing devalued its currency. In 2013, the Dow tumbled 4.4% in August during the initial crisis related to Syria’s use of chemical weapons, and on disappointing results from Macy’s and Walmart. The downgrade of the U.S.’s top-rated credit in August 2011 sent the Dow tumbling more than 4% that month and the slide picked up in September, when fears mounted of Greece defaulting on its debt.

What do these bouts of turbulence have in common? Fears of a slowdown in the U.S. or globally, and worries about another financial crisis. 

There are many theories as to why late summer is a time of malaise for stocks. They include:

* Thinly-staffed trading desks

August is vacation time, when trading desks are not fully staffed. As a result, even the slightest piece of unsettling news can cause a violent reaction in stock prices, especially when trading volume is low.

“I think a lot of the weakness in August and September the last few years has been a combination of coincidence and lower volumes allowing for any bad news to have a greater impact,” Adams says.

* A different investor mindset

Investors returning from vacation often view the market through a new, more critical lens as they plan the rest of the year. 

“They come back in a different mindset,” says Phil Blancato, CEO of Ladenburg Thalmann Asset Management in New York. That mindset is often changed by emerging negative story lines.

"You still need some sort of a catalyst," says Blancato. "Even a minor catalyst in a low volume market will send the market spiraling and it feeds on itself.”

This time around, he says, things that could spook the market include possible shocks, such as monthly retail sales falling more than 10%. Or signs inflation is falling at the same time the Federal Reserve sticks to its plan of reducing stimulus by raising interest rates and shrinking its huge portfolio of bonds. Or potential fallout from any emergence of a smoking gun in the investigation of the Trump administration’s contacts with Russians during the presidential election.

* Reassessing the economy

Recently, a slow start to the year for the economy, followed by a second-quarter pickup, has conditioned investors to be nervous about the third quarter – which August and September fall under, theorizes Jim Paulsen, chief investment strategist at Leuthold Group.

“There are worries about things going cold in the economy,” he says.

However, this year the market is being driven by key bullish underpinnings, he says, such as a U.S. economic that plods along with plenty of jobs and better wages for Main Street, coupled with a broad global upturn in growth. U.S. corporate earnings have also been strong.

“What is getting underestimated,” says Paulsen, “is how good the business fundamentals are.”

Still, with stocks trading near record highs and at pricier levels relative to earnings, the market is vulnerable.

“That is a great psychological cocktail for a knee-jerk reaction if some lousy data point or bad news hits,” says Paulsen. "Because we already have a market on edge we are more susceptible to (a market drop).”

Despite a record that shows August and September to be tough months for stocks, Adams says he doesn’t advise investors “to make investment decisions solely based on seasonality.”

Says Adams, “If stocks go down during these months this year, it’ll be because something unexpected disappointed the market — which is basically the case at any time.”

It’s just that bad news tends to cause bigger waves in the stock market in August and September.