Volatility doesn’t hurt the stock market.
U.S. stocks are off to a rough start to the fourth quarter, with the S&P 500 index down 5 percent since the beginning of October and the Dow Jones Industrial Average dropping more than 1,300 points in a two-day stretch earlier this month. The midterm elections, trade war uncertainty and rising interest rates are among the top concerns for investors at the moment, but LPL Financial chief investment strategist John Lynch says now is no time to panic. Lynch recently listed 10 reasons why the U.S. stock market is still in good shape despite the recent volatility.
Market volatility is overdue.
This quarter’s volatility may be on the extreme side, but Lynch says it comes after the S&P 500 experienced one of its least volatile third quarters in history. In fact, this year was the first time since 1963 that the S&P 500 didn’t have a single day throughout the entire third quarter in which the index moved up or down at least 1 percent. Prior to the early October sell-off, the S&P 500 had gone 74 consecutive days without a single-day move of at least 1 percent, its 10th-longest streak in history.
October is a volatile month.
Not only was the stock market wound particularly tight heading into the fourth quarter, Lynch says the month of October has historically been a volatile period for stocks. In addition to major October crashes in 1929 and 1987, U.S. stocks experienced a dramatic 16.9 percent sell-off as recently as October 2008. In fact, going back to 1950, the S&P 500 has experienced 362 days of at least 1 percent moves during October daily trading sessions, 58 more than any other month of the year. Despite the volatility, overall October returns are roughly average compared to other months.
The economy is fine.
Investors have been particularly concerned with the impact rising interest rates could have on earnings growth. However, the unemployment rate is at 3.7 percent, its lowest level since 1969. Even after three more rate hikes in 2018, the fed funds rate is currently at a range of between 2 and 2.5 percent. As recently as 2007, it was above 5 percent. Lynch says consumer spending is on the rise, business confidence is high, and manufacturing surveys are positive. Even inflation has retreated from 2.9 percent in July to just 2.3 percent in October.
There are pre-election jitters.
If there’s one thing investors hate, it is uncertainty. When it comes to Washington policies, there’s never more uncertainty than the period just prior to elections, which is why the S&P 500 has been relatively weak prior to recent elections. Companies and investors want to know what kind of policy changes to expect from Washington before they invest, and many are likely in wait-and-see mode until the election results are in. In fact, the S&P 500 registered a nine-day losing streak just prior to the 2016 election, one of its longest losing streaks in history.
Expect a post-election boom.
Historically, the period following U.S. midterm elections has been extremely strong for stocks. Since 1946, the S&P 500 has averaged a 30 percent gain off of election-year lows in the year following a midterm election. A 30 percent gain off the S&P 500’s 2018 low of 2,532 would be 3,291, or about 17 percent above recent levels. In fact, the S&P 500 hasn’t produced a negative return in the 12 months following a midterm election since 1946. The next nine months have historically been the best part of the election cycle for investors.
Pullbacks are normal and healthy.
The S&P 500 has been on such a bullish run that it’s easy to forget pullbacks of between 5 and 10 percent are perfectly normal. The 1,300-point, two-day sell-off in the Dow may seem dramatic, but it represented only about a 5 percent drop. Lynch says that the S&P 500 has historically averaged three or four 5 to 10 percent declines per year. And remember, the S&P 500 has averaged at least one correction of between 10 and 20 percent per year since 1950.
Corporations are more profitable than ever.
Wall Street was expecting a 21 percent increase in S&P 500 earnings per share in the third quarter, and early indications from companies that have already reported suggest those bullish estimates may have been on the conservative side. Despite the international trade war, analyst earnings revisions have actually been headed higher rather than lower, rising about 1 percent since mid-September. In addition to a booming economy, tax cuts and a repatriation holiday have injected billions of dollars into corporate balance sheets that companies are using to invest in earnings growth and share buybacks.
Stocks perform well when interest rates rise.
Historical data suggests U.S. stocks typically perform relatively well during periods of Federal Reserve tightening. Rising interest rates typically coincide with periods of economic growth, and Lynch says that description fits the current situation perfectly. When interest rates spike over short periods of time, investors often sell stocks as a knee-jerk reaction. While these sell-offs can be extremely volatile, they are also often relatively short-lived. Lynch says concerns over rising rates now seem mostly priced into stocks. Since 1962, the S&P 500 has averaged a 6.1 percent gain during periods of rising interest rates.
No red flags in leading indicators.
LPL is closely monitoring factors such as excess leverage, over-spending and extreme overconfidence that tend to occur toward the end of bullish economic cycles. Lynch says there are only early signs of potential over-exuberance. In fact, the yield curve on Treasury bonds has actually steepened as of late, a leading indicator that is typically bullish for stocks. Lynch says Fed Chair Jerome Powell is extremely market-savvy and is certainly mindful of stock prices. As of the end of the second quarter, LPL saw a low risk of a U.S. recession in the next 12 months.
An end to the trade war is likely.
The trade war with China has been weighing on emerging market stocks in 2018, and fears about Chinese retaliation has also hurt American stocks. Lynch says a trade deal with China will likely not happen until after the midterm elections. However, the new U.S. trade deal with Mexico and Canada is evidence that a deal can be struck even amid the most heated political rhetoric. The trade war has been criticized on both sides of the political aisle, and an end to the trade war is in the best long-term interest of both China and the U.S.
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