Despite historic hurricanes and flooding, and despite a significant rise in geopolitical tensions with North Korea, the stock market rally actually strengthened during the third quarter, with the S&P 500 gaining 4.4% on a total return basis. As was the case during the first half of 2017, growth stocks continued to outperform value stocks across all market capitalizations. Thanks to a torrid September, small-cap stocks outperformed large-cap stocks with the Russell 2000 advancing 5.6% in Q3. On a sector basis, technology performed the best (up over 8%) while consumer staples had the worst performance (down about 2%). Of note, all 11 sectors rose except for consumer staples.
International stocks again enjoyed a very strong quarter. The MSCI All Country World Index (ex-US), rose by 5.6%. Emerging market stocks, in particular, continued their strong run, up 7.8% during the third quarter.
While lagging equity returns, bonds within the U.S. also generated positive quarterly returns, as the Barclays Aggregate Bond Index rose 0.8%. As has been the case this year, high yield bonds performed the best, up 1.9%. Municipal bonds advanced by roughly 1.0%.
Quarterly Returns Explained
With all the negative headlines, some investors must wonder how the stock market could continue to rally during the third quarter, let alone strengthen. Statistically speaking, after all, it is the seasonally weakest quarter for stocks during the calendar year. Notwithstanding this natural skepticism, the Q3 market rally actually has a very rational basis.
One fundamental underpinning to the rally is a healthy – and strengthening – domestic economy. During the summer months, Q2 GDP was shown to have grown by 3.1%, up markedly from Q1. If anything, economic momentum grew in September as the ISM Manufacturing Index, as well as the ISM Non-Manufacturing Index, rose to multi-year highs. Consumer confidence also is at high levels, as the unemployment rate – among other things – remains low.
Another fundamental basis for the stock market rally is strong corporate earnings. During the second quarter (reported in Q3), the earnings of S&P 500 companies again rose by about 10%, as the larger multi-national companies benefitted from a weaker dollar.
As we have noted before, a still underappreciated fact is that we are in the midst of a synchronized global economic expansion. When combined with relatively low inflation levels, and still accommodative global monetary policy, this has produced a “Goldilocks” backdrop for the world stock markets. Emerging market economies were also aided by the 12% rise in crude oil prices during the third quarter.
Focusing on the seasonally strong fourth quarter, we continue to believe that the path of stocks remains higher. While recognizing that valuations in the U.S. are becoming a bit stretched and that we have not had a market correction in over one year, we still believe that economic and earnings strength will propel the markets to new highs. Indeed, as of early October, all major U.S. stock market indices – the S&P 500, the Dow Jones Industrial Average, the Nasdaq Composite and the Russell 2000 – have notched record closes. An important, but less widely followed index – the Dow Jones Transportation Average – also closed at record highs. Recognizing that the stock market is one of the best, and most reliable, leading indicators, this broad strength sends a positive signal for the months ahead.
Looking forward, we still see no recession over the next twelve months. If Congress manages to enact a corporate tax relief package, that too could provide a substantial boost to 2018 earnings and to market returns. Risks, of course, remain ever present. We continue to monitor the actions of the Federal Reserve and will be interested to see who is appointed to become the next Federal Reserve chair. The selection of someone perceived as more “hawkish” than Janet Yellen could throw some cold water on the rally. All in all, though, we are constructive on the markets for the quarter ahead.
Mr. McFarland is President and Chief Investment Officer at Pennsylvania Trust.
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