Stocks are entering what is historically the worst time of year, and it could be an especially rough ride with the prospect of more Federal Reserve action hanging over the market. The S & P 500 , on average, has declined 0.56% in September, going back to World War II, according to CFRA. The index has been negative 56% of the time in September, but that has set up the market for an average 0.9% gain in October. November and December have both been positive for the S & P with average gains of 1.4% and 1.6%, respectively, CFRA found. Stocks are exiting August with losses. The S & P 500, as of Tuesday’s close was down about 3.5% for the month, and off by more than 7% from this month’s summer high. The index was roughly flat on Wednesday. “I’m thinking we need a good shakeout, probably approaching the 3,800 level,” said Sam Stovall, chief investment strategist at CFRA. He noted the S & P 500 rallied 17.4% off the June low before failing to break above its 200-day moving average on Aug. 16. The 200-day is the average of the last 200 closing prices for an index or a stock, and it is viewed as a positive momentum indicator if it can be surpassed. “I think we could have a retest of the lows, and right now I think the lows will hold,” he said. The S & P touched a low of 3,636 on June 17. This week, the index fell below its 50-day moving average for the first time since July 26. The road map many strategists have laid out for 2022 is a typical one for mid-term election years, in which the stock market sells off hard in September and into October, before rebounding in the final quarter of the year. A negative September would fit that forecast, and the Fed has added to the volatility with its hawkish stance. “I think right now, investors are questioning their core thesis,” said Stovall. He said Fed Chairman Jerome Powell in his Jackson Hole speech Friday discouraged expectations that the central bank would pivot and cut rates once it stops raising interest rates next year. New York Fed President John Williams reinforced that view Tuesday, when he said the Fed would raise rates and keep them high to fight inflation. The Fed meets again Sept. 20 and 21, and odds in the futures market point to another three-quarter point rate hike at that meeting. Strategists expect volatility around the upcoming jobs and inflation data that will help Fed officials determine whether to raise by 0.75 percentage points or 0.50 percentage points, as some economists expect. Friday’s August employment report could be critical. Economists expect 318,000 jobs were added, down from a strong 528,000 in July, according to Dow Jones. Also important will be the consumer price index, released Sept. 13. “Ultimately what we’re looking at is how the Fed is looking at incoming data. Employment is really the key indicator that allows them to throttle how hawkish they want to be,” said Patrick Palfrey, Credit Suisse senior equity strategist and co-head of quantitative research. August employment data is notoriously volatile. The latest ADP report, released Wednesday, showed just 132,000 jobs were added by the private sector. ‘Volatility is the keyword… which makes Friday’s payroll very important,” wrote Julian Emanuel, head of equity, derivatives and quantitative strategy at Evercore ISI. He said Powell’s Jackson Hole speech turned the market to “the dreaded ‘good news is bad news’ dynamic.” A lower than consensus report could help the stock market, but he added a “hot number” of 450,000 or more could send stocks lower. “The Fed is ultimately going to basically set the stage for what the equity markets are going to do,” said Palfrey. Not only do higher prices need to come down, but expectations for inflation need to fall for the Fed to become less hawkish. Palfrey said a retest of the low is possible. “A lot of the valuation excesses we have seen have already come out of the market,” he said. He added that the S & P 500 is now trading at about 16 times earnings, down from about 21.5. He noted a hurdle for the market would be earnings, and “they’ve begun to slide.” Recession worries Palfrey said profits typically decline as the economy heads into a recession, and that is one of the big fears of investors. That could make a fourth-quarter market rebound less likely. “What is difficult is the idea that a recession is on the horizon. A lot of industrial variables look pre-recessionary,” he said. Palfrey said while the monthly employment reports have been robust, the rise in weekly unemployment claims could be an early warning of recession. “This idea that the environment feels pre-recessionary and historically hawkish Fed policy or rising Fed rates has typically preceded a recession, is going to remain a part of the conversation later this year, and early next year,” he added. That could make it difficult for stocks to rally, particularly if profits are under pressure and roll over, he said. Another issue for stocks is likely to come from the fixed income market, where rates have been rising. The 10-year yield was at 3.1% Wednesday, after spending most of July and August below 3%. “Rates and yields look likely to grind higher, so stocks are likely to continue to probe the lower end of the range. After all, it is September,” wrote Evercore’s Emanuel. The strategist said he expects volatility in both directions, and he is not bearish. For one, he expects natural gas prices in Europe may be topping out. He also notes that the inverted Treasury yield curve, in which the 2-year yield is much higher than the 10-year, could be a recession warning. But in 1998, for instance, it took three years for a recession to occur after the yield curve inversion. “Key will be whether the consumer keeps spending or if, after the first ‘almost normal’ summer in 3 years, the spending spigot shuts down,” Emanuel said. Where to invest Credit Suisse’s Palfrey also stressed that rising rates in the fixed income market could add to volatility. “It’s an ecosystem. There’s a splash in one part of the pond and it ripples everywhere,” he said. “If you believe we’re pre-recessionary you’re going to want to shift toward quality type of stocks… health care, staples, defensive sectors. Those are areas where there’s a chance for outperformance.” Palfrey said high-quality tech with strong earnings is also an area he would look to, but the sector overall could have issues. “I think tech is in a tough spot. It comes back to what happens with interest rates. What happens to the cost of capital and essentially what their profit margins are,” he said. CFRA’s Stovall said the best performing S & P sub-sectors since the Aug. 16 high were energy, independent power producers and fertilizers. Of major sectors, only energy continued to gain after the mid-August high, and it is the best performer in August. The S & P Energy Select Sector SPDR ETF, or XLE, mirrors that sector and was up 3.9% for August so far and up 46% for the year. Stovall notes that historically energy, utilities, health care and communications are the best performing sectors in terms of making advances in September. Those sectors were up at least 60% of the time in September, since 1995. Utilities are up more than 4% year to date. Health care is down about 11%, and consumer staples are off by more than 4%. Evercore ISI warns that defensive trades may be getting overdone, especially in utilities, the only sector making a new high since June. Emanuel notes the sector is high priced and dividend yields are near a 20-year low. The Utilities Select Sector SPDR Fund ETF reflects that sector. “With the S & P 500 Utilities Index potentially putting in a ‘double top’ near the upper end of its post-Pandemic trend channel, risk/reward has prospectively tilted toward more Risk, less reward,” Emanuel wrote. Within the S & P sub-sectors, footwear, restaurants and property-casualty insurers were standout performers in September, according to Stovall. These corners of the market were higher 70% of the time, he added.