KEY TAKEAWAYS

  • We’ve just wrapped up the best quarter for the S&P 500 Index since the fourth quarter of 2013, despite a variety of challenges.
  • Continued strength in the U.S. economy and impressive growth in corporate America were key drivers of stock market performance last quarter.
  • The third quarter was a challenging one for the bond market, with the Bloomberg Barclays Aggregate Bond Index flat over the three months.

Investors endured a flurry of trade headlines and emerging market turmoil in the third quarter, but that didn’t slow down U.S. stocks. The S&P 500 Index rose 7.2% during what has historically been the most volatile quarter of the year (7.7% including dividends), its biggest quarterly gain since the fourth quarter of 2013, its best performance in a third quarter since 2010, and the 11th gain in the past 12 quarters. It is also notable that the S&P 500 did not close up or down 1% on any day during the quarter, only the second time in history that feat has been accomplished during the usually volatile third quarter (1963 was the other time). Here we recap the third quarter and highlight some key factors for markets in the fourth quarter.

STOCK MARKET RECAP

The stock market’s third quarter performance was impressive given the tariffs and trade tensions, but those weren’t the only challenges. Fiscal stresses in Turkey sparked fears of contagion in emerging markets (EM), which entered a bear market in August. The Federal Reserve (Fed) raised interest rates for the eighth time this cycle last week and is on track to hike again in December. Long-term interest rates rose during the quarter, but the yield curve stayed flat in what some believe may be a sign of near-term economic weakness. The upcoming midterm elections introduce policy risk. Add to all that the fact that the third quarter has historically been the worst quarter for the stock market. Stocks sailed right through all of these headwinds, extending the longest bull market ever.

The strong performance of the U.S. economy was clearly a primary driver of the market’s strength:

  • Gross domestic product (GDP) grew at a very strong—though likely not sustainable—4.2% annualized pace in the second quarter (reported in late July). With continued support from fiscal stimulus, expectations are for solid 3% growth in the current (third) quarter, based on Bloomberg consensus forecasts.
  • Manufacturing activity remains robust, with the Institute for Supply Management’s Purchasing Manager’s Index reaching a 14-year high in August.
  • Business confidence is strong. Small business confidence in August reached its highest level since 1973, according to the National Federation of Independent Business. The Business Roundtable and Chief Executive magazine surveys of U.S. CEO confidence are both elevated.
  • Job growth remains steady and income growth is accelerating, though not by enough to spook the Fed.

In addition to the solid performance of the U.S. economy, corporate America delivered one of its strongest quarters of earnings growth in decades, supported by tax reform. More stellar earnings growth—likely over 20% based on Thomson Reuters’ consensus estimates—is expected in the third quarter. This would be the third consecutive quarter of earnings growth over 20%.

The overwhelming majority of recent data reflect a solid backdrop, but it’s not all good news. The housing and auto markets cooled; tariffs have started to curb some capital investment; and growth in Europe is slowing.

MARKET LEADERSHIP

In terms of market cap, the globally focused large caps led during the quarter, which is encouraging given ongoing trade disputes with our largest trading partners. The U.S. dollar’s advance paused, which helped U.S. multinationals relative to smaller more U.S.-focused companies. Large cap stocks in the healthcare, industrials, and technology sectors performed particularly well.

Growth stocks maintained leadership over their value counterparts, driven by solid gains for the growth-heavy technology sector. Meanwhile, weakness in the energy and utilities sectors weighed on value. Accelerating economic growth has historically boosted value, but the style has been held back by underperformance in the traditional value sectors.

By region, the U.S. was the place to be, as the S&P 500 strongly outpaced the MSCI EAFE and MSCI Emerging Markets indexes during the quarter. Flare-ups in EM led to some rotation from EM to the U.S., while the U.S. continued to lead major developed nations in economic and earnings growth. Strong gains in domestic consumer discretionary, healthcare, and technology stocks drove most of the performance gap between the U.S. and developed international markets.

SEASONAL TAILWIND?

Historically, the third quarter has seen the worst average performance for the S&P 500 among the four quarters. Stocks far exceeded their historical seasonal pattern last quarter and are up about 10% year to date based on the total return for the S&P 500 Index, which begs the question: Were gains from the seasonally strong fourth quarter potentially pulled forward? As shown in Figure 1, the last three months of the year have historically been the strongest, particularly during midterm election years (based on data back to 1950).

It is certainty possible that the historical fourth quarter tailwind could be muted somewhat given the strong gains this year. Political uncertainty may weigh on investor sentiment as the midterms approach. A strong performance from the Democrats may lead to some rollback of the Republican tax cuts next year. However, a late-year trade agreement with China, which is still our base case, could enable this strong seasonal pattern to hold. (The trade agreement between the U.S. and Canada reached over the weekend is a positive development on the trade front and has the fourth quarter off to a great start.) Investors may also like the political clarity that an election result would bring, regardless of the results.

QUICK THOUGHTS ON THE BOND MARKET

The third quarter was a challenging one for the bond market, with the Bloomberg Barclays Aggregate Bond Index flat over the three months. Year to date, the index is down 1.6%, setting up potentially one of the weakest years ever (the bond market benchmark has only had three down years since 1978). During the quarter, the yield on the 10-year Treasury rose from 2.85% to 3.06%, pushed higher by solidifying Fed rate hike expectations and a modest pickup in inflation.

We still suggest that suitable investors hold bonds in portfolios that may provide some cushion in the event of market declines. Higher rates offered by the short and intermediate parts of the yield curve have provided investors potential opportunities to generate a reasonable amount of income with relatively limited interest rate sensitivity. We continue to recommend mortgage-backed securities and investment-grade corporate bonds among high quality fixed income options. For appropriate investors seeking more potential income, we suggest modest allocations to bank loans or highyield bonds, which carry relatively less interest rate sensitivity than core, high-quality fixed income options but also tend to be more volatile due to credit risk.
 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.

Because of their narrow focus, specialty sector investing, such as healthcare, financials, or energy, will be subject to greater volatility than investing more broadly across many sectors and companies.

All investing involves risk including loss of principal.

DEFINITIONS

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The Institute for Supply Management (ISM) index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

The Industrials Sector consists of companies whose businesses manufacture and distribute capital goods, including aerospace and defense, construction, engineering and building products, electrical equipment and industrial machinery. Provide commercial services and supplies, including printing, employment, environmental and office services. Provide transportation services, including airlines, couriers, marine, road and rail, and transportation infrastructure.

The Technology sector consists of companies that primarily develop software in various fields such as the Internet, applications, systems and/or database management and companies that provide information technology consulting and services; technology hardware & Equipment, including manufacturers and distributors of communications equipment, computers and peripherals, electronic equipment and related instruments, and semiconductor equipment and products.

This research material has been prepared by LPL Financial LLC.

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