The equity markets started off strong in the third quarter driven by the optimism that the Federal Reserve had orchestrated a soft landing for the economy, and the era of policy tightening will soon be over. The major market indexes reached year-to-date highs in July, however, a mixture of negative news, and most importantly, the acceptance of a prolonged period of higher interest rates, led the markets lower in the last two months of the quarter. Following a nearly 5% drop in September, the S&P 500 Index declined 3% in the third quarter. The decline affected both growth and value segments of the markets equally, as well as large, medium, and small capitalization stocks. Despite the negative quarter, most of the major market indexes maintained strong year-to-date returns, led by the NASDAQ’s stellar 27% performance.
Energy was the best performing sector for the last three months and the only one that posted a double-digit return during this period, benefiting from higher oil prices. The communication services sector also finished the quarter with a positive result, led by Alphabet and Meta. All other sectors declined, especially the income oriented real estate and utilities sectors, as high interest rates made more conservative fixed income investments more competitive. The technology, consumer discretionary and communication services sectors continue to lead the way year-to-date.
Developed world markets, as measured by MSCI EAFE, trailed the U.S. markets by a slight margin, mostly due to the strength of U.S. dollar.
The fixed income market struggled in the third quarter as interest rates kept rising. As the interest rate on the 10-Year Treasury note rose from 3.81% to 4.59% from July 1st to September 30th, the domestic bond market recorded its worst quarter of the year with the Bloomberg Aggregate Bond Index dropping 3%.
The U.S. economy grew at an annual rate of 2.1% in the second quarter of 2023, slightly below the first quarter expansion, yet demonstrating remarkable strength in the face of higher interest rates.
American employers added 336,000 jobs in September, the strongest gain since the beginning of the year. This report defied economists’ expectation for a slowdown driven by high interest rates, elevated inflation, and rising oil prices and suggested the economy gained momentum through the summer with the help of strong consumer spending.
On the other hand, some forward looking signs point to a continuing slowdown. The Conference Board Leading Economic Index, a bellwether of economic health, has now declined for nearly a year and a half, including the latest weakening in September. Also in September, the S&P Composite Purchasing Managers Index declined slightly for the fourth month in a row, while still showing a reading greater than 50, which is indicative of growth.
Recent progress in bringing inflation down stalled in September, when the Consumer Price Index rose .04% from the previous month and 3.7% from a year before. While these numbers show that inflation significantly subsided from the 40-year high of 9.1% in July 2022, they were still higher than the target of 2% set by Federal Reserve.
The Federal Reserve made two noteworthy decisions on interest rates during the last quarter. At their July meeting, they voted to increase the federal funds rate target to 5.5%. During the following meeting in September, they kept rates at the same level, but expressed their plans to keep rates at this 22-year high for a longer period than previously expected. While the Fed suggested another rate hike before the end of this year before the easing starts in 2024, the prevailing sentiment is that the Fed is basically leaving room for another rate hike in case inflation surges again.
As we close the third quarter and turn our attention to the fourth quarter of 2023, expectations appear relatively encouraging. As the third quarter earnings season approaches, there is growing optimism due to indications of stronger-than-projected growth. The S&P 500 Index companies’ earnings forecasts for this quarter are somewhat more positive than initial predictions made in July. Moreover, the index is set to experience year-over-year earnings growth, a phenomenon not witnessed since the third quarter of 2022. This resurgence comes as a welcome relief following three straight quarters of decline.
Although the rise in the market after its dramatic plunge in 2020 placed some stress on valuation, the S&P 500 Index trades only slightly above its 10-year average multiples. Investor sentiment, an important indicator of future market direction, has undergone a shift during this time, with bullish sentiments now outnumbering the bearish ones. However, the spread between the bulls and the bears stands at the levels way below those suggesting an overbought market and the heightening risk of a downturn.
Typically, U.S. stocks post their best returns in the final quarter of the year as evidenced by the stock market’s historical performance through the decades with the only exception being the crash of 1987. This historical evidence, along with the strength of our domestic economy and the resilience of the stock market considering the barrage of negative news, at home and abroad, makes us cautiously optimistic about the final quarter of the year and 2023 as a whole. As always, we are here to help you stay on track and keep focused on your personalized long-term plans as well as helping you navigate through the changing markets.
Dumont & Blake Investment Advisors, LLC
September 30, 2023