The third quarter was anything but a typical slow, quiet summer. Stocks had been choppy through June but then moved up in July and powered higher through September. The S&P 500 gained 7.7%, and the Dow moved higher by more than 9% in the quarter. The tech-heavy NASDAQ performed in-line with the S&P during the quarter but was up 17% year-to-date. (That’s how strong momentum has been in tech. Note however that as of the time of this writing, the major averages have given back some of the gains – especially tech stocks – as interest rates moved sharply higher in early October.)
The recent move up in stocks shouldn’t be terribly surprising given the strength of the economic growth data during the quarter. U.S. GDP growth is running at an annualized pace north of 4%. Unemployment fell to 3.7% (September reading), which is the lowest reported rate since 1969. Housing prices continued to rise, which is both a positive and a negative. On the one hand, consumer confidence and spending patterns – 70% of our economy – is bolstered by strong balance sheets, and rising home values add to household net worth. On the other hand, with already-limited supply available, rising prices makes it even more difficult for potential home buyers to stay within budgets. One potential risk worth noting would be a slowdown or reversal in the red-hot housing market. Rising rates, coupled with higher prices, certainly affects affordability and could price some families out of the market. That may be on the horizon, but throughout the last quarter, fundamental indicators remained very bullish.
The big question facing markets is just how quickly interest rates might rise. Most agree that the strength of the economy justifies higher rates, and the Fed has signaled that it plans to continue moving in that direction. Markets and the economy can withstand an orderly “normalization” of rates. Sudden spikes in rates (like we saw earlier this month) will roil markets short-term. The Fed has two formal mandates: stable prices and full employment. However, I would argue that the modern Fed has adopted a third, informal mandate: stock prices. Fed Chairman Powell would never say it, of course, but it feels like the FOMC might back off a little if markets throw a prolonged temper tantrum.
Equity prices have been so strong for so long, lots of new questions are being pondered regarding a potential slowdown in housing, potentially flattening earnings, and a yet-unresolved trade spat with China. And while we rarely comment beyond the quarter just ended, October has already seen a swift and sharp pricing-in of these uncertainties. After the sharp run-up this summer, some weakness at this point seems rational and healthy – a pause rather than the start of something worse. Logically, the strongest momentum stocks going into the end of September are the ones that have given back the most during the pullback, and the major indexes are still only 3-5% off their all-time highs.
Attention now turns to Q3 earnings reports for real-time insight into the health of corporate profit growth. While quarterly announcements are being digested, the midterm elections loom. Predicting election outcomes is like predicting the direction of interest rates – it’s very difficult and unless you’re willing to take enormous risks, being right really doesn’t matter much. A landslide in favor of the democrats would likely be incrementally negative for stocks. The positive is that either way it will be over in a matter of weeks – I’ve seen enough Senate campaign ads from Indiana’s “Millionaire” Mike Braun and “Mexico” Joe Donnelly.