The U.S. stock market registered modest gains last week with most of the major averages up +0.5% - +1.0% on the week.  Perhaps what has been most impressive in Q3 is how well the S&P 500 has performed without the benefit of the Magnificent Seven (MSFT, NVDA, GOOGL, and AMZN are all negative for Q3) – the S&P 500 Equal Weight index has outperformed for the past three months, as investors turned their attention to the other 493 stocks in the index.  With one day to go before quarter end, the S&P 500 cap-weighted index is on track for its strongest Q3 performance since 2020 and the best year-to-date performance since 1997.  The trio of lower yields, falling oil prices, and a weak dollar is an extremely constructive backdrop that likely keeps risk assets flat to higher through year-end.  Not to mention the Fed and global central banks are fully engaged in a monetary easing cycle.

The most important event last week was Chinese policymakers deciding they were tired of seeing the world's second-largest economy remain stuck in a quagmire that has been ongoing for nearly three years.  At the start of the week, China announced a host of monetary stimulus measures (interest rate cuts to several lending rates and a reduction to downpayment amounts for 2nd home purchases), which was followed up later in the week by fiscal stimulus measures targeted at housing, banks, and the stock market.  It was a cornucopia of policy measures that set off a breathtaking surge in China’s stock market.  

One thing we’ve learned in the post-GFC era is that when policymakers start panicking, investors stop panicking.  Over the last eight trading days, the CSI 300 has rallied nearly 25% and is now up over 12% on the year.  The fact that the official manufacturing PMI reported overnight came in contractionary for the fifth straight month (49.8 in September from 49.1 in August, and the Caixin comparable sagging to 49.3 from 50.4 (consensus was 50.5)) did not matter one iota – is a testament to how powerful significant policy measures can be.  Moreover, further slippage in the non-manufacturing PMI to the 50 cut-off threshold for growth – below the 50.3 reading in August and undercutting the consensus forecast of a mild improvement to 50.4, couldn’t cause investors to restrain the buying frenzy.

Now, before you allow greed to overwhelm prudence, keep in mind that the problems in China run deeper than what can be overcome by policy alone.  Sure, this will help and, without question, alter depressed sentiment and positioning metrics. Still, a deflationary balance sheet recession (which is what China is dealing with) takes time and pain to resolve.  A 25% surge in its equity market over eight trading days smacks of a short-covering rally on steroids.  So, I wouldn’t advise chasing right here, right now, but as I’ve penned in previous missives, the setup is there for emerging markets to potentially outperform U.S. equities for the first time in over a decade.  Part of the reason Chinese equities launched higher in the manner they did is because they were detested and deemed ‘uninvestable’ by the broader investing community.  Not to mention, they were trading at a mere 10x forward P/E multiple – one of the steepest valuation discounts since 2010.  Bottomline, we have the seeds for a bullish rotation to EM and international equities in Q4 as long as U.S. employment holds up and recession risks stay at bay.  A recessionary decline in the U.S. labor market, a disorderly rise in bond yields, and/or a resurgence in the U.S. dollar dramatically changes the setup – in which case everything, but the U.S. dollar and short-term T-bills get hit.  

Meanwhile, copper and iron ore had big weeks on the back of the China news, and gold continues to make new highs.  Gold is up more than +27% ytd and up +40% over the past year (besting the Nasdaq, S&P 500, and the Dow).  It has outperformed the U.S. stock market over the past twelve months and over a three-year basis.  I will say, though, that investor attention to its performance is starting to catch on, and sentiment is getting a little ahead of itself for the gold market.  So, I wouldn’t get too eager to chase it here, but I still advocate for those underexposed to pick your spots and buy on dips. 

Yields on the 10-year Treasury have been up more than 10 basis points since the Fed's 50bps cut, which isn’t unusual historically as investors tend to shift to equities based on the belief that the Fed will manage to avert a recession.  Chicago Fed President Austan Goolsbee’s (one of the most dovish Fed Presidents) gave a speech last week at the National Association of State Treasurers Annual Conference laying out the case why the Fed has a lot more work to do in recalibrating interest rates:

“If we want a soft landing, we can't be behind the curve.” 

“Inflation is way down from its peak. Indeed, for multiple months, it has actually been coming in at the 2% target—and expectations data suggest the market doesn’t think it’s going back. The unemployment rate at 4.2% is at the level many consider sustainable full employment. Basically, we would love to freeze both sides of the Fed’s dual mandate right here.” 

“Yet rates are the highest they’ve been in decades. It makes sense to hold rates like this when you want to cool the economy, not when you want things to stay where they are.” 

“Rates need to come down significantly going forward if we want the conditions to stay that way.” 

Another variable at play regarding U.S. interest rates is the extent to which a premium is starting to be built on the premise that neither presidential candidate seems interested in enacting fiscal policy with a focus on belt-tightening.  Both Harris and Trump are campaigning on more fiscal goodies which will not help in the inflation fight as we get deeper into 2025 –  a point in time where our modeling suggests inflation could be back to grabbing investors’ attention (in a bad way).  There is no doubt that the longer end of the curve is starting to build in more of a fiscal risk premium now that both candidates are dreaming up more ways to bust the national budget. Whoever wins the White House, let’s all pray that we end up with a split Congress to provide the checks and balances and prevent some of these reckless fiscal policies from ever seeing the light of day.

As for the upcoming week, we have a litany of incoming economic data to gauge the health of the U.S. economy: ISM manufacturing PMI, JOLTS, and Construction spending on Tuesday, ADP on Wednesday, Challenger job cuts, Initial Jobless Claims, and ISM services PMI on Thursday.  The main event will be the BLS payroll report on Friday where consensus is expecting a number around +150k.  Over the past three months, job growth has averaged +116k, and the six-month average is +164k, so the consensus is looking for a bit of a reacceleration here – we’ll see.  Where the number ultimately comes in will be consequential for the Fed where the futures market is 50/50 on whether we see a 50bps or 25bps cut on November 7th.  Nevertheless, the market is pricing in 75bps of cuts by year-end, so a hot number will definitely push the probability for a 50bps cut down and cause ripples throughout all capital market pricing.

A bit of trepidation runs through me when thinking about how to articulate and present the data I’m about to discuss because it gives the impression that the results are obvious and easy to come by.  What I’m talking about is the total returns of the S&P 500 going back to 1970, which show that the S&P 500 has delivered a positive total return more than 80% of the time over a one-year time span (validates the widely understood adage that stocks generally appreciate over time).  Over five-year intervals, the probability of a positive return only improves – as in 90% of the time and 95% of the time over a 10-year time horizon.   Why own anything else?  Well, for starters, the sequence or path that returns follow matters greatly to someone living off and withdrawing from a pool of capital.  Ask anyone in such a position during the 2000-2002 bear market, 2007 – 2009 bear market, or even the short-lived (but gut-wrenching) 35% during the Covid Pandemic in March/April 2020.  

In the nearly 54-year span from 1970-2024, the S&P 500 has delivered an average annual total return of 12%.  If you take away nothing else from this data, take this away: the equity market is indeed a reliable asset class for building long-term wealth.  But also understand that stocks have gone through prolonged stretches where the total return was close to flat: 1906-1924 (19 years), 1929-1952 (24 years), 1966-1978 (13 years), and 2000-2012 (12 years).  The post-GFC run in equity markets over the past 15 years is one of the best 15-year time periods in history. However, what is missing in just looking at the price chart is the extent to which investor mood can push things to optimistic and pessimistic extremes. 

The chart below illustrates what frustrates prudent professionals in the investment industry.  If earnings truly are the ‘mothers milk’ to equity performance, then astute market participants need to recognize and consider that other factors come into play when trying to understand stock market performance.  The blue-shaded area shows earnings have grown fairly consistently over time, which is a fundamental justification for stock prices to go up.  But the pink shaded region (Forward P/E) is less quantitative and more qualitative as it shows the extent to which investors are willing to pay up to own stocks  

Anyone can wake up this beautiful morning, pick up their phone, pull up the scoreboard on the stock market's year-to-date performance, and correctly conclude it's been an outstanding year. However, they likely don’t spend too much time attempting to understand what is driving such gains because it's too complicated. And I get that. There are more times than I care to admit that things don’t quite make sense to me or comport with my analysis.  But when you are charged with stewarding someone else's capital and the responsibility of success or failure carries with it the weight of life-changing consequences, it’s imperative to have a better fundamental command of what is driving what and why than just the simplicity of reading the scoreboard.      

The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.

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