3Q18 Insights

As we enter the 4Q we are seeing additional nasty cross currents at work in the stock and bond markets. A stock market correction of some magnitude that many have been predicting (too early by most) may finally be happening. The S&P 500 is down 3.5% from the October 3^rd high and the Nasdaq Index is down 6.5% on the same basis. It appears the Nasdaq could be headed for the 7550-7350 level based on prior support levels, which would be about a 7%-9% pullback from the August 30 high. Stay tuned!

The 3^rd Quarter was very positive for the major stock market indices – with the S&P 500 rising 7.7% (most of the YTD gain of 10.6%) and with the Nasdaq gaining 7.4% (less than half of its 17.5% YTD return).

Growth stocks continued to outperform value stocks during the quarter and YTD. Growth stocks have been outperforming value stocks for the last 5 years or so, with short periods of value stocks doing better. Whether growth stocks will continue to outperform in the quarters and years ahead remains to be seen.

Bond returns were steady during the quarter, basically reflecting the coupon interest. Since the end of the quarter, however, bond prices have fallen rather dramatically with a symmetrical rise in yields. The 10-year Treasury Note has risen above 3% and to the highest levels in 7 years. This rapid rise is part of what is driving stock prices down in the short term. The recent good news for the bond market and U.S. economy is that the yield curve has steepened a bit, somewhat reducing the worry of the curve becoming inverted, which in the past has been a warning of economic slowing.

The U.S. economy remains very strong. One could argue that the stock market spent the 3^rd Quarter catching up with the economy. Going forward, it appears that the Federal Reserve Bank will be the final determinant for steady domestic growth and steady returns from financial assets. It must walk carefully the fine line between its desire to normalize real interest rates and causing additional stress in the emerging markets and global economy. Inflation is running close to the Fed’s goal and appears not to be a major concern for now.

When the current pullback in stock prices has run its course, whether it is 3% to 6% or 6% to 10% from recent highs, we expect the 4^th Quarter to eventually provide a positive return from stocks. Since 1928 the 4^th Quarter has usually been the strongest quarter of the year. We believe the fiscal policies and regulatory easing will provide more lift than the downward pressure from the concern over the trade war (which now is mainly with China given the agreements with Mexico and Canada) and the mid-term elections. Mid-term election history suggests that stock prices do well following the elections regardless of which party gains or loses seats. We expect 1-2 more interest rate hikes by the Fed over the next six months and for the 10-year Treasury to level off early next year.