Overview- The market moved higher in Q3, with the S&P 500 up +5.8%. The market rally appears to be broadening with Midcap, SmallCap and Value doing as well as if not slightly better than the S&P 500. This is a marked contrast from the first half of the year, where the top 10 names in the S&P, by market cap, were responsible for about 75% of the S&P returns in the first 6 months of the year. (See exhibit 1) However, the quarter was not without volatility as concerns over the “yen carry trade” caused a fast, almost -10% pullback in the market.
Valuation/Sector and Style- We still believe that the market is expensive, but begrudgingly “for a good reason”, as signs of a soft landing are clear in the economic data, and the Fed is no longer tightening. We continue to see far better valuations in areas outside of large cap tech and have added exposure to small, mid and international stocks. Exhibit 2 shows that the most attractive area of valuation resides in small/mid-caps and value vs. growth. Further, exhibit 3 shows that irrespective of market direction, when the Fed cuts rates, small caps generally outperform large caps. This view would be solidified by clear signs of an expanding economy, but we believe that current rich valuations support the notion of being invested in areas other than large cap tech. We have also built up some exposure to more cyclical parts of the economy, along with gold and other commodities.
Economy- Generally, the data continues to support the notion that a soft landing is occurring, albeit in an environment where there is more weakness in the lower half of the economy than the upper half that owns assets. Until we see concerning signs of an emerging slowdown, we believe this is the most likely scenario.
Inflation/Rates- Rates declined during the quarter as positive signs of waning inflation continue to emerge. However, October has ushered in concerns over a rising deficit, and this has reversed most, but not all of the decline in rates during 3Q. We are positioned with a duration slightly less than the benchmark as we believe rates will likely stay in a range with an upward bias as we go through the election. We are not currently in the camp that sees a new high in rates (the 10Yr Treasury is close to 4.30% right now and the high was 5% last year). We do acknowledge that a red or blue wave will usher in new spending programs which will likely add to the deficit concerns. We will be monitoring our trend following models and the economy and inflation to test our thesis.
Trend- Outside of a bearish signal early in 3Q, our models are reflecting a positive trend. Volatility could be reasserted as the election comes, so we will be watching carefully and do have a modest conservative tilt as the market is somewhat overbought.
Sentiment / Seasonality – The 4Q is typically positive, and post-election action is usually positive for the equity market, so seasonality favors additional market upside. We see few signs of excess euphoria that we would normally associate with a secular high. The market has broken out to a new high, relative to the early 2022 high, but sentiment doesn’t seem to be as widespread bullish as it was then. In that sense, until we see higher signs of euphoric speculation, the market could climb the proverbial “wall of worry”.
Conclusion / Geopolitics – We seldom worry about geopolitics. Geopolitical concerns rarely have a long-term effect on interest rates, the economy and earnings. Most events are almost always relegated to brief concerns that go away as quickly as they come. However, a major concern, that might jeopardize a year-end rally, is the possibility of a Blue or Red wave from the election. If the House, Senate, and Executive branch are all controlled by one party, the historical record shows that stocks do not favor such an outcome. The reason is that gridlock is good for stocks, while focused government power in all branches is not.
With that disclaimer, we see a gridlock outcome as a modest positive for equities as we go into 4Q. Clearly there are valuation concerns, especially in large cap and growth, that can only be sustained by improving earnings, and interest rates holding around current levels. If Goldilocks happens, then we could see earnings growth continue and be sustained by the Fed easing rates. If there is a wave, it will likely add considerable volatility to both fixed income and equity markets.
