The month of October can be scary; and I'm not talking about Halloween
Friday, October 6, 2023
As I initially sat to write this early Friday morning, futures were down as we awaited jobs numbers. Now however, a few hours later, the S&P 500 is up over .93%. How today will end? Who knows for sure, but it looks promising.
(If "wonky" talk is not your thing, now might be a good time to skip to the bottom * for a summary!)
THE OPPORTUNITY
The fourth quarter has historically been the best for stocks, and it hasn’t been a particularly close race. The S&P 500 has posted an average gain during the quarter of 4.2%, widely outpacing the underwhelming 0.6% average gain in the third quarter. Furthermore, the index has finished higher nearly 80% of the time in the fourth quarter. While we can’t say with certainty why the quarter’s performance historically sticks out, it does usually overlap with updated full-year company guidance for the following year, portfolio window dressing into year-end, overall holiday season optimism, and of course a good starting point due to weak September seasonality. Looking ahead, with the S&P 500 up 11.7% year to date as of September 29 (quarter end, by the way), another 4.2% on top of that would make for a pretty good year.
WATCH FOR A POSSIBLE MID-TO-LATE OCTOBER LOW
The month of October hasn’t historically been one of the best months, ranking sixth over the past five years, third and fourth over the past 10 and 20 years, and seventh since 1950. Not too exciting. But if you peel back the onion and look at the average path of the S&P 500 over a calendar year you will see stocks tend to bottom in October. That means those strong fourth-quarter rallies don’t typically start until we’re a couple of weeks or so into the quarter. It also means the best two-month period of the year for the S&P 500, on average, is November and December, which we wrote about here last week. Expectations for volatility also tend to come down as we move into October. The CBOE Volatility Index, more commonly referred to as the VIX or ‘fear gauge,’ jumped as much as 40% last month as investors bid up the cost of hedging downside risk. While the move higher was significant, it is not surprising given volatility is mean reverting, and the VIX came into September at a three-year low. In addition, the VIX historically advances in September before finally peaking on the year near the end of September/early October—around the 40th week of the year, which happens to be this week.
This market may be set up for that fourth-quarter rally we often see, but several things have to happen for the markets to deliver.
AS RATES GO, SO GOES THE STOCK MARKET
This market may be set up for that fourth-quarter rally we often see, but several things have to happen for the markets to deliver. Perhaps the most obvious potential catalyst for a fourth quarter rally is lower interest rates. From a fundamental perspective, rates have been driven higher by a U.S. economy that has continued to outperform expectations, pushing recession expectations out further, and by the unwinding of rate cut expectations by the Federal Reserve (Fed) to be more in line with the Fed’s “higher for longer” regime. These dynamics have led to a dis-inversion of the yield curve, with the 10-year yield rising faster than the 2-year (called a bear steepener). Perhaps surprising to some, given inflation expectations remain relatively well anchored, the move higher in yields recently has been more about improving economic growth and fixed income investors essentially demanding additional compensation for owning longer maturity Treasuries (referred to by bond wonks as the bond term premia). It has not been about rising inflation expectations. So, where do we go from here, after this relentless move higher of 0.8% in only three months? A lot of the aforementioned catalysts have played out, in our view, but until the economic data softens, which we expect over the next several months, we’re unlikely to see meaningfully lower yields. A re-acceleration in inflation or central banks globally selling more Treasuries, where the supply/demand picture is tenuous, could push rates higher. As such, from a fundamental perspective, we’re likely going to see yields in the 4.25% to 4.75% range throughout the rest of 2023, along with the potential to see further flattening of the yield curve, and thus yields, across the curve at or above 5%.
UPCOMING EARNINGS SEASON OFFERS ANOTHER POSSIBLE CATALYST
While falling rates are the most obvious potential catalyst for stocks to rally through year-end, third quarter earnings season starts in a couple of weeks and carries the potential to buoy investor sentiment. For one, third quarter results may bring an end to the earnings recession. Second, results excluding energy sector earnings declines have been excellent relative to expectations in the last few quarters. Third, economic growth based on third quarter data has continued to exceed expectations, pointing to potential GDP growth north of 3%. And finally, though energy sector profits will be down, recent strength may leave analysts’ estimates overly conservative. Pushing in the other direction and something that may cap earnings upside for multinationals is a strong U.S. dollar, up about 3% vs. a broad basket of currencies since June 30.
*ENOUGH OF THE WONKY TALK
In short, markets have pulled back in recent weeks. But if history is our guide, they’ll bounce back higher and stronger. While being patient, we’re continuing to look for good buying opportunities as we zig and zag our way through some economic headwinds.
In the event I haven’t told you lately, we appreciate you and value our relationship! Please know that each day, we have your best interest in mind as we help you reach your preferred financial future. And, to that end we work!
Blessings—
Jim
PS – SHAMELESS PLUG: The following link is to a podcast hosted by James Willis of Brighthouse Financial. He is talking with LG Pannell about the importance of our "Health-Span". Certainly worth a listen (but of course, I'm biased!)
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