by Jordan Hucht, CFP®, ChFC®, AIF®

Q3 Review: The Gain Train Rolls On  

The summer’s market action was highlighted by a sharp correction, followed by a quick recovery with broader participation as investors cheered the arrival of long-awaited rate cuts. The third quarter came to a close with the S&P 500 at a new all-time high, capping off the fourth consecutive quarter of gains.

With the Fed now embarked on a rate-cut journey and an economy that’s avoided recession, is the road ahead a smooth one? If not, what will it take to derail the gain train that’s been rolling since last fall? Let’s take a look under the hood to see what’s kept the engine running and what could cause a stall in the months ahead.

On the surface, the story has been much the same since the end of last year, when Jerome Powell essentially signaled that the Fed had reached peak rates in its inflation-fighting rate-hike campaign. With lower rates coming and the widely predicted recession proving elusive, stocks have rallied higher and bonds have delivered their best returns in years. The story was threatened twice this year – once in April by sticky inflation numbers and then again in August by weak employment numbers – but in each case, we got back to script after a few weeks. And the results have been strong, with the S&P 500 rising approximately 20% through the end of the third quarter.

Though the headline narrative may seem relatively unchanged, not everything has remained consistent. If pending rate cuts and resilient economic data were what gave the market confidence, it was the excitement around AI that really drove stock prices higher during the first half of the year. This was evidenced by a handful of mega-cap tech companies (most notably, Nvidia) with outsized performance influence skewing the overall index higher, whereas the rest of the market lagged considerably behind. For example, the tech-heavy Nasdaq rose more than 18% in the first half of the year, dramatically outpacing the industrial-focused Dow Jones’ gain of less than 4%. The broader S&P 500 gained almost 15% in the first half, which illustrates the outsized impact that mega-cap tech has on the overall market.

The third quarter, however, saw a departure from this trend. Though it was another positive quarter for the market as a whole, we saw a rotation in leadership. The red-hot Nasdaq was essentially flat for the quarter, but the Dow Jones rose nearly 8%. Overall, the S&P 500 tacked on another 4% during the quarter. One of the primary concerns about the sustainability of the market’s rally earlier in the year was its narrow breadth. As I noted in last quarter’s newsletter, we started to see some broadening of the rally in the beginning of the summer, and that trend expanded during the third quarter. On the margin, that’s a positive – a narrow rally can only last so long, as the stocks leading the rally will eventually reach a point of exhaustion when prices become unsustainably justified. A broader rally, by definition, has greater participation and less concentration risk.

Another thing to pay close attention to is the source of the price increases we’ve seen in the stock market. In other words, how much of the gain is a product of increases in actual earnings versus expansion of multiples? Let’s take a look. At the beginning of the year, the S&P 500 was trading at approximately 19 times expected earnings for the year. At present, the index now trades at approximately 21.5 times projected earnings over the next year. That represents multiple expansion of 13% for an index that’s gained 20% this year, with earnings growth making up the difference.

The conclusion? This year’s market gains are a combination of higher multiples and higher earnings, but we need to keep an eye on valuations. For context, the average multiple on the S&P 500 over the past 5 years is approximately 19.5 and closer to 18 if we look back 10 years. However, we’re still meaningfully below the 23x multiple we saw in 2021 (but keep in mind what that lead to in 2022). I think the takeaway here is that stocks are currently priced with a lot of optimism built in; though not at the overstretched levels of a few years ago, threats to the current sanguine sentiment could create sharp corrections.

What could those threats be? On the interest rate front, the Fed has been clear about its intent to gradually bring rates down to a neutral level over the next 2 years. A material change to that intended course, whether due to inflation or unemployment surprises, would cause a recalibration of stock prices. Similarly, corporate earnings are projected to grow by 15% in 2025. That’s significant growth, and if earnings don’t deliver to those levels, the high valuations we discussed wouldn’t be justified. Beyond fundamentals, geopolitics could play a significant role in near-term market trends. Though the outcomes of US presidential elections historically don’t have much longer-term impact on financial markets, the lead-up to next month’s election is sure to bring with it some drama that could rattle near-term investor sentiment. Meanwhile, tensions in the Middle East continue to escalate and pose a real threat to short-term market outcomes. Obviously, this is only a short list of potential negative catalysts, and we need to keep in mind that it’s oftentimes the things that aren’t widely being considered that can be the most disruptive.

Prudent financial planning and investment management requires planning for unseen threats and unexpected outcomes. That can mean remaining vigilant and disciplined in the face of broad optimism. I think Ray Dalio expressed it best when he said:

“The more you think you know, the more closed-minded you’ll be.”

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Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. All indices are unmanaged and are not available for direct investment by the public. Past performance is not indicative of future results.