Is the Record Run Sustainable? Q4 Stock Market Concerns

Despite the month’s reputation as a notoriously difficult period for equities, stocks defied the odds in September, rising to trade at record highs.

The S&P 500 achieved its greatest year-to-date performance of the 21st century by rising 5.5% in the third quarter, resulting in a nearly 21% increase in the index over the first three quarters.

However, the three months were tumultuous. Investors confronted recessionary concerns and uncertainty regarding interest rates during July and August, resulting in some of the most favorable and unfavorable trading days in recent memory.

In September, the Federal Reserve, for the first time in four years, reduced interest rates by 50 basis points, thereby joining the ranks of global central banks that are alleviating monetary policy. This action boosted equities. The reduction, as per officials, was a preemptive measure to provide support to the labor market, which, according to data, is slowing but not collapsing.

Analysts are generally optimistic about the prognosis, despite acknowledging the possibility of increased volatility, as the fourth quarter has historically been a strong one for stocks.

The Labor Market in Focus

Throughout the fourth quarter, investors are expected to prioritize the economy, as they did in the third quarter. Wall Street will be particularly attentive to labor market data for indications of decline that would cause concern for the Federal Reserve.

According to analysts at Russell Investments, initial unemployment claims will be a critical data point to monitor. Claims data, which is published on a weekly basis, exhibits a lower degree of latency than other labor market data. “These will provide the clearest real-time guidance on whether the U.S. economy is rebalancing or drifting towards recession,” according to the researchers.

In their opinion, initial claims that exceed 260,000 per week would serve as a warning sign. As of late September, the four-week average was approximately 225,000.

In their most recent economic projections, Federal Reserve officials anticipated an additional half-percentage-point reduction in interest rates this year. The Federal Reserve may implement more assertive policies during one of its two policy meetings in response to an increase in unemployment and job losses. This would align interest rates with market expectations; however, it would also likely frighten investors and cause some damage to stock portfolios.

Stocks Perform Well Following Soft Landing

There is a general consensus on Wall Street that the Federal Reserve is likely to achieve the soft landing it has been pursuing for years, which is a positive development for equities.

The Atlanta Fed’s GDPNow calculator projected that the U.S. economy expanded at an annual rate of 3.1% in the third quarter as of late September.

Recessions occurred during six of the most recent ten rate-cutting cycles. In those cases, the S&P 500 experienced an average decline in the year following the initial reduction. The average return in the four cycles that coincided with gentle landings was in the high teens.

The conventional wisdom is that small-cap equities should benefit the most from interest-rate cuts, as they are more likely to have floating-rate debt. Nevertheless, BlackRock analysts discovered that large caps have outperformed small caps during rate-cutting cycles since 1984, and that the outperformance is most pronounced outside of recessions.

Healthcare and consumer staples have demonstrated the most favorable performance during rate reduction at the sector level, while communication services and technology have been the least successful.

For the first time since 2022, the aggregate earnings of the S&P 500 grew in the second quarter, with the exception of the Magnificent Seven. The profitability gap between tech megacaps and the rest of the market is anticipated to continue to narrow in the third quarter, with companies expected to begin reporting their results in mid-October.

In contrast, the Mag 7 is confronted with the challenge of persuading Wall Street that their substantial investments in artificial intelligence (AI) will yield positive results. During the summer, they encountered difficulty in accomplishing this, which resulted in selloffs that the group has yet to fully recover from. If the earnings of these stocks do not meet the high expectations of Wall Street, they may continue to be subject to pressure.

Volatility May Be Enhanced by Politics

Even if they do not significantly alter the economic or business outlook, political developments are likely to increase stock volatility throughout the remainder of the year.

One such event that could cause a temporary jolt to Wall Street is the presidential election in November. According to BlackRock’s analysis, the market’s knee-jerk reaction to a presidential election is usually not indicative of its performance over the next year. Nevertheless, the presidential candidates have established stances on corporate taxes and tariffs that, if implemented, would undoubtedly alter the business climate in the United States.

As long as they pose a threat to disrupt global trade or agitate energy markets, conflicts in the Middle East and Ukraine could also maintain a high level of volatility in the stock market.

Nevertheless, volatility is a two-way street that can offer astute investors the opportunity to acquire equities at attractive valuations, according to experts. An increase in volatility can also accelerate short-term returns. Since 1990, the S&P 500 has averaged a 16% return in the six months following a Cboe Volatility Index increase of 29 or higher, in contrast to an average return of 5% in less volatile period.