Can U.S. equities rally and how far? Following a period of time that the Standard & Poor’s 500 index traded essentially sideways from the end of 2014 through the end of June 2016, and resulting negative investor sentiment, it’s the question on everyone’s lips in the final quarter.
To many, the S&P 500 index looks like it’s spoiling for a fall, trading at a price-to-earnings multiple of 17, when the historic median over the past 40 years is 13.8. A pullback, particularly around the time of the U.S. presidential election or a Federal Reserve rate increase, wouldn’t surprise. But if it does happen, it’s unlikely it will be meaningful or lasting.
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There are good reasons to be bullish on equities in the fourth quarter, the most obvious of which is oil prices. Last year, crude went from $45 a barrel at the end of the third quarter to $26 in February 2016. Now crude oil is at $49 a barrel, and fourth-quarter earnings will almost certainly be higher than the fourth quarter of 2015, partly due to the recovery in oil prices. In addition, we expect that the S&P 500 should begin to price in 2017 estimated earnings over the course of the quarter, which are 14 percent greater than 2016 consensus expectations. And earnings are one of the most potent drivers of stock prices.
There’s also no need to sweat the Fed. Yes, rate rises have the potential to weigh on stocks, but not right now. The Federal Open Market Committee decided not to raise rates in September and indicated that “lower for longer” continues unchanged. Fed Chair Janet Yellen has also since said there is no fixed timetable for raising U.S. rates as the economy continues to recover.
If the Fed raises rates at all this year, it will likely be in December, and only by about a quarter of a percentage point, or 25 basis points. That will bring the total amount of rate rises so far this cycle to a “whopping” 50 basis points. That’s hardly reason to panic.
A 25 basis point rise will be ultimately be cheered by the market, as a sign that the Fed is finally able to move away from the brink of zero, and normalize rates.
A rate hike would also signal a stronger economy, which is good news for earnings. In fact, investors will decide that better quality earnings resulting from actual sales, rather than corporate finance strategies like stock buybacks, will justify higher price-earnings multiples.
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The only time rate hikes have really hurt stocks is when bond yields have risen to levels that make them competitive to stock dividends. That appears to be a long way off, with the S&P 500’s dividend yield at around 2.15 percent in September, when the benchmark 10-year Treasury note yield was less than 1.6 percent.
Growth stocks will benefit in the fourth quarter, if the economy continues to recover and especially if stronger data warrants a rate rise. Likewise, value stocks should do well, as year-over-year earnings comparisons will likely become easier in the fourth quarter for stocks in sectors such as energy, materials and industrials. However, defensive high-dividend paying sectors like utilities and consumer staples, could sell off.
Any weakening of defensive sectors should help to tip the scales back in favor of active management strategies. Many active managers have suffered this year because they have found it difficult to justify paying 30-plus percent valuation premiums for some defensive companies that have been all the rage this year, despite their anemic growth.
The wild cards to watch out for in the fourth quarter include the U.S. presidential election, which could always result in a Brexit-style surprise outcome. Another is a rising dollar, which would put pressure on earnings and weaken our stronger earnings argument. But a rising dollar is more likely to occur if the Fed aggressively raised rates — something that doesn’t seem likely.
Also, the dollar’s strength has been offset by the European Central Bank deciding in September not to push further into negative rate territory, as well as the Bank of Japan deciding to target a decline in real yields, rather than further negative rates.
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Disclosure: Investing involves risks including the possible loss of principal. In general, equities securities’ values also fluctuate in response to activities specific to a company. Past performance is no guarantee of future results. This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.
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Fourth-Quarter Seasonality Should Be No Different This Year originally appeared on usnews.com
