It’s always great to start with the words, “The markets finished the quarter at an all-time high.” Fortunately, that’s the case this time around. The S&P 500 rose 2% in September and 5.5% for the entire quarter. The Dow, meanwhile, gained 8.2% in Q3. Both indices set new records along the way.
So, in this letter, let’s quickly recap why the markets performed the way they did over the last three months. Then, I’ll tell you what I think might be the most interesting storyline from an investor’s perspective. We’ll finish with a few things to keep an eye on as we draw closer to the end of the year.
July
The quarter began with the markets already rebounding from a bout of volatility in early Q2. This was driven by good news regarding inflation, with consumer prices dropping to 3% in June. That led to renewed optimism that the Federal Reserve would finally cut interest rates sometime in the summer. But as July started making way for August, the skies over Wall Street began to turn cloudy. The optimism of a future rate cut shifted into concern that maybe, just maybe, the Fed had already waited too long.
August
Rumblings in the labor market primarily drove this concern. Unemployment has been trending upward for some time now, and in July, the jobless rate rose to 4.3%. While that’s not a high number historically, it was still higher than most economists expected. It prompted investors to wonder whether future rate cuts would be enough to prevent unemployment from rising higher, which could trigger a recession.
Just as investors were chewing over this unpleasant data, the markets were hit by another interest rate whammy – this time, from overseas. While our rates have been at 40-year highs recently, Japan has kept their rates extremely low. Because of this, many investors were using a tactic called the yen carry trade. This involves borrowing Japanese currency at an absurdly cheap rate and converting that cash into a stronger currency. With that stronger currency, investors could buy U.S. securities at a discount. It’s been a popular tactic, but it unraveled in early August with the news that Japan was finally raising interest rates while the U.S. prepared to decrease theirs. That meant the yen was stronger in value than before. As a result, many investors were forced to quickly sell off the assets they bought before having to pay higher interest rates on the money they borrowed. This triggered a short but massive selloff across the entire globe.
All this was unpleasant but, thankfully, fairly short-lived. By the end of August, the markets had completely regained what they had lost. Still, a sense of uneasiness remained because September had historically been the worst month of the year for the markets.
September
True to form, the markets began the month with another dip. Besides worrying about unemployment, investors were also mulling over the future of artificial intelligence. (More specifically, the companies that have invested heavily in it.) AI-related hype has been one of the biggest drivers of the current bull market, but far more money has been poured into AI than has flown out of it. Some analysts raised whether the new technology is all it’s cracked up to be and whether it will truly return enough value to shareholders to justify its costs.
But then came the news everyone had been waiting for. The August jobs report was modestly positive, indicating that unemployment was unchanged. (In other words, it is still higher than anyone would like, but it is not picking up momentum.) And the latest inflation report was even better: Inflation had fallen to 2.5%. The lowest mark since early 2021…and very close to the Fed’s goal of 2%. A rate cut was now all but certain. And on September 18, it finally happened. The first cut in over four years, to the tune of 0.50%. Based on this, the markets continued to climb, finishing the quarter at record highs.
So, Q3 was an action-packed quarter with plenty of twists and turns. But as much fun as it is to say “record highs,” that may not even be the best news.
Warren Buffett once said that interest rates act like gravity on valuation — meaning they pull stock prices down or at least prevent them from rising too high. But despite higher rates, stocks have been in a bull market for the past two years. How can this be?
When discussing “the stock market,” we consider it a single entity. But that’s far from the truth. As its name implies, the S&P 500 comprises five hundred companies, and the broader stock market contains thousands. Some companies are rising in value at any given time, while others are falling. The markets do well when more companies rise than fall, and vice versa. But sometimes, you don’t need a lot of companies to rise in value. You just need a handful to rise so much that they drag the index’s overall value along with it. That’s been the case for much of the past two years. Most of the market’s rise has been driven by a handful of tech giants, thanks to the AI boom I mentioned. However, for most companies on the stock market, growth has been much more modest. Interest rates act like gravity, remember?
One of the most interesting storylines is that this trend reversed last quarter. More than 60% of companies in the S&P 500 rose higher than the overall index in Q3. (For the previous quarters, it was only around 25%.) And the Russell 2000 index, which contains many smaller companies, rose by 9.3% for the quarter.5 All this suggests that the bull market is widening in breadth, a positive indicator for the future. (The broader a market incline, the longer that incline tends to last.)
Now, with all that said, there are still some question marks on the horizon that we need to keep an eye on. While geopolitics rarely has a sustained impact on the markets, conflict in the Middle East could inject turbulence into oil prices, which affect the markets to a degree. Volatility can always spike in the weeks before and after a presidential election. And the biggest question mark is unemployment. Can the Fed achieve a soft landing, avoiding a recession as they continue cutting rates? These are the questions that only the future can answer.
For these reasons, it’s important we remain prudent with our investment decisions in the short…while always keeping our focus on the long term. In the meantime, enjoy the upcoming holiday season! As always, please let me know if you have any questions or concerns. My door is always open.
