The benchmark S&P 500 posted a modest 0.2% gain for the 3rd quarter as multiple concerns countered earnings results that continue to outpace analyst estimates. Stocks struggled to generate consistent upward momentum, and mid-September brought the first 5% pullback in almost a year. The market typically exhibits two to three of those episodes in the average twelve month stretch. Earnings reported during the quarter topped expectations by 16% and posted a 92% year-over-year gain measured against the period impacted by the pandemic period’s strictest lockdowns. Interest rates drifted slightly higher despite monthly inflation data showing some of the highest prints in decades. That muted bond market behavior indicates investors believe supply-chain bottlenecks will ease and producers will eventually balance output with strong demand. More two-way price movement likely indicates the stock market entering a mid-cycle stage.
The U.S. economy grew 6.7% during the 2nd quarter and has now passed the level of output seen prior to the pandemic’s onset. Projections of future economic activity have moderated since June, but the consensus expectation is that U.S. GDP will expand at an annualized 5% over the second half of 2021 and above-trend growth will continue through 2022. Labor market recovery was choppier during the 3rd quarter, with August payrolls figures coming in healthy, but well below forecast levels. Renewed health concerns weighed on activity and hiring in service industries, but demand for workers in many industries is quite strong. The higher wages needed to fill those roles could be a positive for consumer spending going forward. Given a combination of government assistance and curtailed spending over the past 18 months, household balance sheets are quite healthy, and that factor bodes well for the consumption that makes up around 70% of G.D.P. Low interest rates continue to boost the housing market, and that strength has a multiplier effect on overall economic growth.
The broad market advanced during the 3rd quarter, but returns varied across sectors. Heavily cyclical Materials, Industrials and Energy posted negative returns as economists dialed back growth expectations. That sort of market reaction shows the stock market, as ever, remains a forward-looking mechanism. Financials topped all sectors with the benefit of interest rates well off their 2021 lows factoring into share prices. Communication Services topped all sectors ex-Financials on strength in streaming entertainment and increasing online advertising momentum. Technology posted strong relative returns, fueled by excitement heading into Apple’s annual iPhone launch. Healthcare trailed close behind, offering a combination of both defensive qualities and growth opportunities in an uncertain market. That lack of clear direction helped Utilities top the S&P 500, as investors sought the sector’s trademark stability and consistent dividend income. Real Estate performed roughly in line with the benchmark, as the defensive nature and dividend profile offset the impact of a stalled re-opening. The Consumer sector lagged the broader market as fewer consumers were out and about shopping and choppy job growth created a cloudy outlook for spending. The mid-cycle phase doesn’t favor a particular sector, so market leadership will likely flip-flop repeatedly.
Moving toward the mid-cycle market phase means earnings tend to drive stock returns as price-earnings ratios fall or remain stable. Higher quality companies with stronger balance sheets and industry-leading positions also tend to fare better during these periods. At the end of the day, investors are looking for management teams to deliver on the earnings front, and reporting season for 3rd quarter results starts in earnest in mid-October. In stock market terms, the rising tide will no longer be lifting all boats, and it will again be evident that holdings selection matters in what is a “market of stocks” rather than a broad “stock market”. The focus on earnings will inject some volatility in the market as quarterly updates surprise to the upside or the downside and share prices react accordingly. That volatility is a feature of the market, not a symptom of any other influence. Investors would be well-served to focus on the long haul, as waiting out short-term gyrations has historically paid handsome rewards.