Many readers remember the sudden and sharp S&P 500 declines around this time last year. 2018’s fourth quarter was harsh, to say the least. From the S&P 500’s highs in early October through Christmas Eve, the index dipped into bear market territory with a near perfect -20% decline.1 Technical market watchers would rightfully label this decline a bear market, but throughout history the dangerous bear markets have tended to be the ones known for size and duration. Since last year’s Q4 ‘bear market’ only lasted a day, it likely won’t be remembered in the annals of stock market history.
The S&P 500 in 2018: A Sharp Q4 Correction
Source: Federal Reserve Bank of St. Louis2
In last year’s fourth quarter, trade uncertainty was rising, global economic growth was positive but slightly decelerating, and the Federal Reserve was raising interest rates. In the current quarter (Q4 2019), global growth remains in the same middling decelerating pattern, but the Fed has lowered interest rates three times and “Phase 1” of a potential trade deal is driving some optimism in the markets. In other words, conditions are quite different in 2019 than they were in 2018, and the S&P 500 has been trending modestly higher.
The S&P 500 YTD 2019 Through October 31: A Smooth Start to Q4 (So Far)
Source: Federal Reserve Bank of St. Louis3
To be fair, however, we now have an environment where the global manufacturing sector is in recession, business investment is softening, and corporate earnings are on pace for their third straight quarter of declines. So, what has me convinced that the S&P 500 will finish 2019 in solidly positive territory? I’ll give you three reasons.
Reason #1: Positive Signs are Being Ignored
Regular readers know my opinion that markets love to climb the “wall of worry.” The wall of worry forms when investors get so latched onto the recession narrative that pessimism pervades the airwaves, and people prefer to cling to negative news while ignoring positive developments.
We see this happening quite a bit today, with significant positive news being overlooked, such as:
- The yield curve turned positive with few people noticing
- Solid and consistent gains in the labor markets continue apace
- Consumer spending continues to grow at a healthy clip
- The all-important ISM non-manufacturing index continues posting readings in solidly expansionary territory
- And so on down the line
Instead of the narrative being that the U.S. economy is charting a modest, but healthy growth path in-line with a long-term trend of 2%, the narrative is instead focused on a matter of when, not if, the U.S. will enter a recession. This disconnect between sentiment and reality is bullish, in my view.
Reason #2: Recession Risks are Already Deeply Discounted in the Markets
In a recent Barron’s poll, 27% of money managers said they had a bullish outlook on stocks, compared to a year ago when 56% of managers were bullish.4 Many managers – and investors – have shifted into defensive positions over the past year, with historically defensive sectors like Utilities and Consumer Staples leading the charge of market gains in 2019. These sectors now look fairly expensive relative to cyclicals, in my view, which I believe creates an opening for mean reversion.
Reason #3: Trade Uncertainty Will Start to Lift, Bringing Sentiment with It
This week has brought with it several developments on the trade war front, with China and the U.S. appearing to agree that tariffs will be reduced or even phased out as part of “Phase 1” of the trade deal. Part of the reason business investment – and arguably manufacturing – have been softening is because of uncertainty surrounding the trade war. I believe that as we inch closer to clarity and the prospects of early innings of a deal, some of this uncertainty will lift and we could see a bounce-back in fixed investment and factory activity.
Bottom Line for Investors
Since 1926, the S&P 500 has entered the fourth quarter with double-digit gains on 42 occasions. In 35 of those years, the index continued its ascent through year-end, posting an average gain of +4.5%. In the post-World War II era, the S&P 500 has averaged a +3.8% return in the fourth quarter.5
These metrics are reassuring, and history can be useful in helping us assign probabilities to outcomes. But my real point in sharing those metrics is to demonstrate that last year’s dreadful Q4 was an anomaly in history. At the end of the day, stocks have gone up more than they have gone down, and I’ve got three reasons to believe this year’s Q4 will fit this historical pattern.