It was another tough week for stocks. The S&P 500 Index was down just shy of 4% last week, briefly dipping intraday into correction territory (more than 10% off the all-time high) and putting October on track to be the weakest month for stocks since the financial crisis. Concern about an earnings slowdown and a potentially overly aggressive Federal Reserve (Fed) seemed to be the primary drivers, but market participants saw little, if anything, encouraging out of the other “bricks” in the stock market’s wall of worry. These include the U.S.-China trade dispute, Italy’s deficit spending, Brexit uncertainty, Saudi tensions, and policy uncertainty ahead of midterm elections. An exhaustive list for sure, though based on closing prices the S&P 500 has managed to avoid a 10% decline from the record high on September 20.
So where do we go from here?
As we discussed here two weeks ago, this type of volatility is not unusual. The S&P 500 has endured three pullbacks of 5–10% this year, right in line with the long-term average. The two corrections this year are more than is typical, but not unusual—the S&P 500 has endured two or more corrections in a year nine times in the past 50 years. In the years since 1950 that the S&P 500 was positive, stocks averaged an 11% maximum peak-to-trough decline, which is what the S&P 500 experienced in January–February of this year. October has also historically been the most volatile month, based on the number of 1% or larger daily moves.
Putting this volatility into perspective can be reassuring, while several positive fundamental and technical underpinnings for stocks are also comforting. Some possible catalysts for stocks to rebound include:
Elections are coming. Regardless of what stocks do over the next week, the midterm elections are now just six days away. That clarity, regardless of outcome, has historically been a positive catalyst for stocks (recall the nine-day losing streak for the S&P 500 ahead of the 2016 presidential election). Since 1946, the S&P 500 has never been down over the 12 months following midterm elections (18 for 18).
Elections aside, we have entered a favorable seasonal period. November and December have historically been two of the best months for stocks. In fact, when a year-to-date gain at the end of September becomes a year-to-date loss in October, as was the case this year, the S&P 500 has historically rallied strongly off the October lows [Figure 1]. In general, fourth quarters are the best quarter of the year for stocks, and November through April (which starts this Thursday) has historically been the best six-month period.
The U.S. economy is in excellent shape. Gross domestic product (GDP) grew at a 3.5% annualized pace in the third quarter, better than consensus (3.3%), after the 4.2% pace in the second quarter. The two-quarter average is the strongest since 2014, despite some drag from exports due to the ongoing trade dispute with China, and fiscal stimulus remains supportive (more on Friday’s GDP report in today’s Weekly Economic Commentary). Looking forward, our favorite leading indicators point to the potential for continued economic growth.
Corporate profits remain quite strong. Despite all the anxiety around corporate profits, consensus now expects a 25.2% increase in S&P 500 earnings per share in the third quarter, above the 24.9% pace in the second quarter (Thomson Reuters data). Estimates for the next four quarters have also been quite resilient, falling only 0.2% since earnings season began, despite many companies citing tariff costs. Estimates for 2019 have actually inched higher during October, which is surprising given the market reaction to some of the earnings shortfalls over the past two weeks [Figure 2].