U.S. financial markets have entered the dog days of August and the second lightest volume period of the year, making big moves less likely until traders and fund managers return to their desks after Labor Day. As a result, major benchmarks could just run in place, with narrow ranges limiting profitable opportunities for buyers and sellers. It's best to enjoy the breather while it lasts because the fourth quarter could match last year's gut-wrenching volatility.

It has been all sweetness and light since Dow component Walmart Inc. (WMT) eased trade war anxiety last week, posting healthy numbers across the board. Target Corporation (TGT) followed suit on Wednesday morning, breaking out to an all-time high near $100 after raising 2020 earnings per share (EPS) guidance. However, retailers have been reluctant to estimate the tariff impact due to mixed messages from the White House and lingering hopes for a trade deal.

It's also assumed that the Federal Reserve will cut interest rates, providing a continued stimulus for the U.S. economy, but neither Chairman Powell nor President Trump knows if those actions will keep a floor under the economic expansion. The summer trading crowd has become hyper-sensitive to retail sales in response to this doubt, hoping that strong consumer spending continues after the next round of tariffs hit store shelves in September.

Given upcoming catalysts, it will be tough to navigate September and the fourth quarter market by looking in the rear-view mirror. Stating it another way, strong earnings and economic reports are shedding light on past performance that may not reflect market conditions into year end. And ominously, the bond market has looked at the future and sees a brick wall dead ahead, taking a view that now conflicts with the stock market's late August complacency.

VIX Weekly Chart (2015 – 2019)

VIX
TradingView.Com

The CBOE Volatility Index (VIX) has posted two major peaks in the past four years, starting with a surge over 50 during August 2015's replay of the 2010 flash crash. Market watchers hope and pray that type of event won't happen again, but there are no guarantees. Many folks have already forgotten the second peak above 50 in February 2018, when the stock market turned sharply lower after the president fired the first shot in the trade war.

The plunge into December 2018 failed to match the volatility of the first quarter event, lifting briefly into the upper 30s before turning tail and dropping back to multi-year support in the low teens in the first quarter of 2019. Two flurries of selling pressure since that time have posted lower highs in the 20s before crushing volatility breakout buyers and returning complacency to the ticker tape.

Now look at the complex pattern carved by the weekly stochastics oscillator since it crossed into a buy cycle in March 2019 (shaded area). Three upward impulses have failed to reach the overbought level or the red line that has marked the turning point for four volatility events since April 2017. This coiling activity suggests that the financial markets will undergo a final and more dramatic shock in the "bull" cycle that started five months ago.

Algorithms and their masters feed on volume and volatility to build market-making profits, so there's little incentive to generate big highs or lows during one of the lightest volume periods of the year. They also know that September has booked the worst returns of any month since 1950, with 31 up years, 38 down years, and an average -0.62% return. As a result, it makes perfect sense for them to take a break, allowing tariff implementation and Chinese retaliation to get the ball rolling downhill. (See also: Why People Say September Is the Worst Month for Investing.) 

The Bottom Line

U.S. stock markets have paused in light volume conditions after an early month decline, setting the stage for volatile fourth quarter price action that could rival 2018's intensity.

Disclosure: The author held no positions in the aforementioned securities or their derivatives at the time of publication.