Schwab Market Perspective: Crunch Time

Key Points

  • Stocks regained their footing as the Fed remained on hold yet again. The fourth quarter, however, features many potential market moving events, and October has offered some nasty surprises in the past. We believe this earnings season is important to the near-term future of the bull market.
  • Some recent U.S. economic data has been weaker than expectations and we’ll be watching for coming releases to see if it’s only a soft spot or something more concerning. We lean toward the former but the answer will go a long way to determining if we see a rate hike in 2016.
  • World trade has been in focus due to the election and there are both concerning issues and bright spots when looking at the global trade picture.

Investors are gearing up for the fourth quarter

Sports fans know that the fourth quarter is often when much of the game-deciding action occurs, and that may be the case for the stock market this year. The Federal Reserve has pushed the possibility of rate hike this year into the final quarter; the long-awaited return to positive earnings growth could be in store this quarter; economic data needs to show signs of bouncing back; and then of course there’s the U.S. election. Any or all of these could have a substantial impact on stocks. Add in what has a historical tendency for some pretty nasty October surprises, and the potential for an increase in volatility persists.

We continue to believe the secular bull market which began in 2009 is ongoing, but that we’re in a mature phase likely to see some discomforting bumps along the way. Timing these pullbacks right is extremely difficult and we urge investors not to try. Instead, stick with your long-term asset allocations and view pullbacks as a chance to add to positions as needed. If the risks are causing you to lose sleep, we suggest looking into potential hedging strategies, which could cost you some money to implement, but may also keep you from making a bigger investing mistake.

Earnings take the ball

After five consecutive quarters of declining corporate earnings, the coming reporting season could prove to be important to the near-term state of the bull market. With valuations at least modestly elevated by most measures, earnings need to start to carry the weight if this bull market is to advance. Earlier this year, analysts were expecting the third quarter to see earnings growth move back into positive territory according to Bloomberg; but recent downgrades have resulted in a consensus of still-negative growth. If the so-called “beat rate” (the percentage by which companies ultimately exceed consensus expectations) is consistent with the recent past, the quarter could see earnings back in positive territory. But if earnings disappoint, the market could be vulnerable.

According to Bloomberg, analysts are expecting a 10% earnings growth rate in the fourth quarter and a robust 16% growth rate in 2017. This seems a bit on the optimistic side and leaves the market vulnerable to an increase in volatility should those expectations have to be again downgraded. The collapse in the oil market is now in the rear-view mirror, which should help to solidify both the energy and basic materials sectors’ earnings growth rates. And the stability in the dollar has also removed what had been a headwind for exporters and the industrials sector.

Economy needs a fourth quarter comeback

Economic data has been mixed over the past month. It started with soft Institute for Supply Management (ISM) readings at the beginning of September and continued with some weaker-than-expected housing data. Housing starts fell 5.8% in August and building permits dropped 2.3% according to the U.S. Census Bureau; while the National Association of Realtors reported that existing home sales fell 0.9% in August. The Chicago Fed also reported that their National Activity Index fell to -0.55 from 0.24, which has had a pretty good correlation with manufacturing activity in the past.

Chicago Fed confirms soft ISM reading

Chicago Fed confirms soft ISM reading

Source: FactSet, Institute for Supply Management, Federal Reserve. As of Sept. 27, 2016.

We’re also seeing some signs of potential weakening of the auto market, which had been on a solid run. According to Cornerstone Macro Research, the percentage of banks tightening auto loan standards is now over 8%, not a lot but up from negative territory in the first quarter (indicating more banks were loosening standards). This is likely due to the number of subprime loans that are now 60 days or more delinquent, which is up 17% year-over-year. Not surprisingly, this softer economic tone filtered through to the Index of Leading Economic Indicators, which fell 0.2% in August, although the previous month’s reading was revised slightly higher.

Leading Indicators confirm recent softness

Leading Indicators confirm recent softness

Source: FactSet, U.S. Conference Board. As of Sept. 27, 2016.

Not surprisingly, the Atlanta Fed has had to decrease its estimate of third quarter gross domestic product (GDP) growth as a result of the weakness seen. Their “GDPNow Tracker” has fallen from an annualized growth rate of 3.6% at the beginning of August to 2.9% in their most recent projection.

At this point we believe this is temporary softness brought on by a very quiet August when more folks than usual seemed to be on the sidelines; and are looking for a comeback in the fourth quarter. Continuing historically-low initial jobless claims reading (a key leading economic indicator), the low unemployment rate, rising wages and consumer confidence, and ongoing accommodative monetary policy lead us to believe that the economy will continue to muddle through into 2017.