Pennsylvania Trust

A Summer to Savor

A Summer to Savor

Photo of George McFarlandQ3 Recap

The U.S. stock market continued its strong advance in the third quarter with the S&P 500 rising by 7.7% on a total-return basis – its best Q3 performance since 2010. Several new record highs were made during the quarter, most recently on September 20th when the S&P 500 closed at 2930. Year-to-date through September 30th, the S&P 500 gained an impressive 10.5% (including dividends).

As was the case during the first half of 2018, growth stocks continued to dramatically outperform value stocks across all market capitalizations. However, unlike the first half of the year, large cap stocks outperformed small cap stocks, with the small cap S&P 600 Index up “only” 4.5% for the quarter. Not surprisingly, by style, large cap growth turned in the best performance and small cap value the worst.

All eleven sectors in the S&P posted positive total returns with health care turning in the best quarterly performance, up over 14%. Energy and basic materials had the worst quarterly performance, up less than 1%, as Nymex crude oil prices declined 1% while other commodities, such as copper, were down as much as 5% or more.

International stocks, overall, as measured by the MSCI World Index, ex-U.S., did relatively poorly during the third quarter, gaining 1.3%. Of note, emerging market stocks continued to fall, losing about 1.1%. Year-to-date through September 30th, emerging market stocks are down 7.7%, while developed international stocks (using the MSCI EAFE Index) are off a more modest 1.4%. Hurting foreign results was a U.S. dollar that continued to strengthen in the quarter (up 0.4%) and slowing economic growth abroad made worse by tariff concerns.

The U.S. bond market again was relatively flat during the third quarter. The U.S. investment grade taxable bond market, as measured by the Barclays Aggregate Index, rose by a very modest 0.02%, on a total return basis, while the overall investment-grade U.S. municipal (tax-exempt) bond market suffered very modest losses. High-yield bonds performed the best, both in the taxable and tax-exempt markets.

Q3 Returns Explained

For investors in the U.S. stock market, it was a summer to savor. Underlying the summer rally was a strong – and strengthening – domestic economy. The Commerce Department, for example, reported that Q2 GDP grew by 4.2%, up markedly from Q1. For the first half of 2018, GDP grew by over 3%, and indeed, the Federal Reserve and most economists foresee full-year GDP growth at or above 3% – the strongest annual growth in years.

With over 70% of U.S. GDP coming from consumer spending, it is important to note that consumer confidence, as measured by the Conference Board, hit an 18-year high in September, undoubtedly due to robust employment and rising wages. Reflecting the strong employment picture in the U.S., September saw new (i.e., initial) unemployment claims hit a 49-year low dating back to 1969. Small business optimism also hit multi-decade highs – a key fact as much of hiring within the U.S. is done by small businesses. While not nearly as important to U.S. GDP, manufacturing output also continued to expand during the quarter – – hitting the highest levels since 2004 in August, according to the ISM manufacturing index.

Despite the strong domestic economic performance, inflation (and inflation expectations) remained near “goldilocks” levels. In particular, August core PCE inflation (the Federal Reserve’s preferred inflation gauge) came in at 2% year over year – exactly matching the Federal Reserve’s 2% inflation target. At its September meeting, the Federal Reserve commented that it does not see inflation rising beyond 2.15% over the next several years. If the Federal Reserve is correct in its forecast, inflation will remain neither too hot nor too cold, a market-friendly result.

Also underlying the summer rally was continued strong corporate earnings growth. With the last of the Q2 earnings reports in, the S&P 500 companies on average grew their earnings by 25% in Q2, matching the robust Q1 results. According to Factset, strong (approximately 19%) earnings growth is forecast for Q3 as well. For the full year, S&P 500 earnings growth is projected to rise by approximately 20%.

What’s Next

With the domestic economy and corporate earnings strong, and with the S&P 500 still trading at valuation levels (approximately 17x forward earnings) well below peak multiples in past bull markets, it is likely that further gains will be seen. Importantly, the next U.S. recession will not likely occur until the next decade. After all, there has never been a recession while corporate profits are rising – and even in 2019, when the rate of earnings growth for the S&P 500 companies is forecast by Factset to slow to 7% or so, this still represents rising profits.

To be sure, the list of potential headwinds is long. Due to slowing economic growth outside the U.S., we no longer are experiencing the degree of synchronized global economic expansion that fueled strong 2017 global stock market results. While Q3 ended with the outlines of a trade deal in place between Canada, Mexico and the U.S., trade concerns – particularly with China – remain. Geopolitics, including Brexit and rising populism in Europe, continue to cloud the international outlook. Within the U.S., risks to the economic outlook center upon the impact of rising interest rates, which increase the cost of borrowing money – a factor that already is causing some slowing in the housing market. Of course, too, the mid-term elections are looming which, if nothing else, can create uncertainty during October and early November.

Apart from these tailwinds and headwinds, seasonality supports a positive Q4 outlook. The fourth quarter traditionally is a strong quarter for the equity markets and typically is even stronger in mid-term election years. According to Strategas, in fact, the S&P 500 since 1950 has gained 7.8% on average in Q4 during years where mid-term elections have been held. And looking ahead to next year, Strategas also observes that the S&P 500 has never declined in the 12 months following a mid-term election since 1946.

The bottom line for now is stay the course with a well-diversified portfolio featuring high-quality U.S. stocks.

As always, we encourage you to reach out to us with any questions, concerns, or perspectives you may have. Please contact your portfolio manager, or you may reach us at 610-975-4300, or email

Mr. McFarland is President, Chief Executive Officer, and Chief Investment Officer of Pennsylvania Trust.

Disclosure: This Commentary represents a review of topics of possible interest to Pennsylvania Trust’s clients and is not personalized investment advice. It contains Pennsylvania Trust’s opinions, which may change following the date of publication. Information obtained from third-party sources is assumed to be reliable but is not guaranteed. No outcome – including performance – is guaranteed, due to various uncertainties and risks. This document is not a recommendation of any particular investment. Investment decisions for clients are made on an individualized basis and may be different from what is expressed here. Past performance is no guarantee of future results.