Q3 faced fluctuations that raised concerns about current bull market momentum and longevity. Seasonally, August and September are the weakest months of the year, and pullbacks are common. The S&P 500 ended the quarter with a modest 3% decline while stocks fell 5.9%. Headwinds created by rising interest rates applied pressure to the bond market, decreasing values by 3.2%, and the U.S. 10-year Treasury yield, which increased 80 basis points to 4.6%, its highest since 2007.
Yet, despite a weaker backdrop in Q3, the longer-term uptrend remains intact, and our macro models indicate that it is more likely a pullback than the start of a new bear market decline of 20% or more. Furthermore, historical data shows that despite its volatility, October often brings a market correction that ultimately leads to a positive gain by year's end in 82% of cases since 1980. Our risk metrics and indicators have also remained stable during this correction, reducing the likelihood of a significant downturn.
Earnings expectations are also encouraging, with a forecasted 11% increase in S&P 500 earnings compared to last year's 5% decline. The Fed seems poised to conclude its interest rate hike cycle, and the narrow gains of the first half, driven by a small handful of large-cap tech stocks, have broadened in the third quarter, creating a more sustainable backdrop for the bull market case. As a result, heading into the fourth quarter, the best seasonality of the year with an average gain of 4.1% since WWII, we see increased potential for a year-end rally.
Presenters:
Tom Samuelson, CFA, CMT, Chief Investment Officer, Vineyard Global Advisors
Kendall Dilley, CFA, CMT Portfolio Manager, Vineyard Global Advisors
Sam Caylor, Investment Analyst & Senior Trader, Vineyard Global Advisors
Original Broadcast: Wednesday, October 25th, 2023
The recent pullback reflects the type of correction that aligns with historical bull market patterns. A cursory glance at the S&P 500 Index from 2020 to the present shows the COVID-19 crash that triggered a 35% drop in one month. Subsequent global interventions fostered a strong, emerging bull market, characterized by higher lows and higher highs while trading above a rising 200-day moving average, signaling that the longer-term trend is moving upward—the pattern of a bull market.
Toward the end of 2021, concerns over froth and valuations ultimately led to last year's 28% drop and resulting bear market, nearly the 31% average drop since 1929, characterized by lower lows and lower highs. Since then, valuations have reset, and we've returned to a bull market pattern, experiencing only minor pullbacks. The market hovers near the 200-day moving average, a crucial juncture to sustain higher lows and higher highs.
Solid earnings estimates, favorable stock valuations, broadening markets, and a potential end to the Fed tightening cycle all contribute to the continued bullish sentiment. It's early days in the bull market, so it's not unusual to experience some pullback, particularly in the seasonally weak months of August and September. The current bull market, having begun approximately a year ago after October's lows, represents less than one-third of the average three-year duration for bull markets since 1929, suggesting continued momentum ahead.
The International Monetary Fund's projections anticipate a global growth slowdown from 3.5% to 3%. However, this is seen as a soft landing, not necessarily indicative of a recession. High-frequency data sets, including Purchasing Manager indices, show that most global economies remain resilient despite the economic challenges. However, concerns linger as the average S&P 500 company is down 2.2%, emphasizing the need for a broader pattern of higher lows and higher highs across various indices to gain bull market conviction.
The yield curves steep inversion fuels persistent concerns about a recession. The recent surge in interest rates also compounds a bearish outlook, potentially leading to stock revaluation. Unexpected events, like the October 7th attack on Israel, raise geopolitical concerns with repercussions extending to global players like Russia and North Korea.
Other metrics, such as the Value Line Composite and Dividend Stocks, face challenges with 4.5% and 10% declines, respectively. Additionally, Bonds have encountered three consecutive years of loss, approaching their long-term average after a record 13% loss last year. A potential post-Covid office vacancy and commercial real estate crisis still looms.
Bringing inflation under control is a positive in the current economic landscape, with the year-over-year Consumer Price Index (CPI) hovering at 3.7%, edging ever closer to the Fed's 2% target. Earnings have demonstrated resilience influencing a recovery in stock values. While geopolitical concerns linger, the primary issue facing markets is the 100 basis points surge in interest rates since July, affecting stock multiples that previously justified a range of 19 to 20 times earnings.
The 10-year yield has risen from 4 to 5%, corresponding to a 9% market decline. Factors include concerns over increasing deficits, the Federal Reserve's shift from buying to selling bonds, and banks divesting due to low-rate losses. Households are now picking up the slack to fund deficits, which demand higher interest rates. The upside is that 5% on a 10-year Treasury offers a more attractive real rate of return.
There's potential relief on the horizon as the Fed may have finished raising interest rates and is actively reducing excess liquidity from the market. As liquidity dwindles, the market could interpret this as the Fed ending its quantitative tightening, easing the pressure on stocks and stabilizing interest rates.
Interest rates and stock valuations are correlated, and when interest rates are lower, you’re generally willing to pay higher stock prices. Currently, stocks are trading at 19.1 times earnings in the S&P 500, which is above the long-term average associated with a 6% interest rate. If rates rose to 6% and stocks were to revalue to their long-term average, this could result in a 13% decline in the stock market.
However, the market is fairly valued in the high fours and if there's no recession in the new year, earnings could increase by 8%, making stocks more attractive. While the cap-weighted S&P 500 is trading at 17.6 times 2024 earnings, the average stock within the index is below its long-term average, presenting a potential opportunity for investors.
Geopolitical risks, particularly the Israeli-Palestinian conflict, are currently a concern. While these tensions historically had limited global economic impact when contained within Israel's borders, several scenarios are possible. A confined conflict would likely have a minimal global impact, affecting crude oil prices by + $ 4 per barrel.
However, an escalation involving Hezbollah and Iran could shave 0.3% off the global economy and raise crude oil prices substantially by $8 per barrel. A direct military confrontation between Israel and Iran, likely involving the U.S., could potentially cause a significant reduction in global GDP by one-third and skyrocket crude oil prices by an estimated $64 per barrel.
Regardless of how the situation unfolds, there's ample capacity in Saudi Arabia, the United Arab Emirates, and Kuwait to mitigate disruptions should potential sanctions on Iran lead to a loss of oil supply.
Despite a seasonal pullback in the third quarter and October’s annual volatility, the market remains resilient. A Q4 rally is possible, given broader market participation, lower interest rates, and a potential end to the Fed’s rate hike cycle. Our current strategy includes maintaining benchmark exposures with added cash for defense, with readiness for adjustments if needed. As we enter the fourth quarter, a cautiously optimistic approach seems prudent, given current market dynamics. Still, we will be watching the situation closely.
*All data sourced through Bloomberg.
