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Market Commentary: Another October Bottom?

Stocks had a solid late-week reversal higher, even as many worries and concerns piled up. From the U.S. House not having a speaker for the first time ever, to yields soaring, to deficits and spending, the list of worries was high. But there’s an old saying that the market tends to rally on a wall of worry. As we noted in early August, there was a little too much optimism as long-term bears turned bullish, opening the door for seasonal third-quarter weakness. Now in October we think a low could be near.

  • Stocks tend to bottom in October, and we think another major low is near.
  • The bull market turns one this week, which is a good sign as the second year of bull markets tend to be strong.
  • The September payroll report confirms the economy is strong.
  • Aggregate income is rising above the pace of inflation, and that’s powering the economy.
  • Wage growth is easing, which should alleviate concerns that the economy is overheating.
  • Expectations for a stronger economy are driving interest rates higher.

According to data from our friends at Bespoke Investment Group, 18 of the 60 market corrections (classified as a pullback of 10% or more) bottomed in October. Last year at this time, stocks were in the midst of a vicious bear market and inflation was soaring, yet they finally bottomed and started to rally. While the data did not significantly improve, it wasn’t as bad as investors feared. With many signs of worry reaching high levels lately, another market low may be near and the bull market will likely continue. What could spark the rally? We think it will be a stronger economy (more on this below).

Stocks fell close to 5% in September, but this month hasn’t been good for stocks historically. So it was somewhat normal, even if it wasn’t fun. Encouragingly, years in which stocks fell at least 3% in September but remained higher year-to-date saw a nice bounce in October. The fourth quarter was also higher every time and up more than 9% on average. We believe a year-end rally is likely.

The Bull Market Turns One

The bull market will officially turn one this week, with stocks up about 20% over the past year. The bull market’s first year is in line to be the worst since 1988, which followed a historic bear market.

However, 1989 saw a gain of 29.0%, which was the best second year of a bull market ever. Additionally, out of 15 major bear market lows going back to 1950, the second year after the bear ended was higher every time, with an average gain of 13.5%.

The Economy Is Strong

It doesn’t get much simpler than this: The U.S. economy relies on consumption, and consumption comes from income. Overall income in the economy is dependent on three factors:

  • Employment growth
  • Hourly wage growth
  • Number of hours worked

All of the above are running strong, and so overall income growth across the economy is strong. That is powering consumption. In fact, weekly income growth has run at a 5.2% annual pace over the past three months. That is higher than the pace of inflation. The Federal Reserve’s favored measure of inflation, which is based on the personal consumption expenditures index, has run at an annual pace of 3.3% over the last three months.

No Signs of a Slowdown, which Is Spooking Investors

The economy created 336,000 jobs in September, blowing past expectations for a 187,000 increase. A large part of the growth was government jobs (+73,000), but even the private sector created 263,000 jobs. Not only that, payroll growth in July and August was revised higher by 119,000. So, over the last three months, payroll growth has averaged 266,000 per month. That compares to an average of 201,000 in the second quarter.

In short, the economy has strong momentum going into the fourth quarter, especially amid myriad concerns, all of which we have written about (strikesstudent loan payment restartgovernment shutdown). The unemployment rate was steady at 3.8%, but that’s well below historical levels.

However, the strong economy is spooking investors. Investors have pushed bond yields much higher over the last three months. The 10-year Treasury yield is now above 4.80, compared to 3.80 at the end of June.

What’s interesting is that short-term interest rates haven’t budged. The market doesn’t think the Fed will raise rates again, which is why the implied policy rate expectation for 2023 has remained steady at 5.5%. Instead, as the chart below shows, the expected policy rate in 2027 has surged, from about 3% in May to 4.35% today. That’s a massive move, and it has happened because investors expect the Fed to keep rates higher well into the future.

Why have long-term rate expectations risen? The simplest answer is that investors think the economy is likely to strengthen. The surge in yields has come as economic data has shown signs of a much stronger and more resilient economy over the last three months. Investors are projecting that into the future. But that is also likely to keep inflationary pressures higher, which means the Fed must keep rates high to counter inflation. My colleague, Barry Gilbert, wrote about this recently.

In short, a stronger economy is pushing long-term yields higher, and that’s scaring investors into thinking that higher borrowing rates will push the economy into a recession. That fear has created volatility in equity markets. If that doesn’t make sense to you, don’t worry, it shouldn’t.

We think good news for the economy is good news for the markets. Ultimately, profits come from economic growth, and that will eventually play out — perhaps sooner rather than later, as earnings season kicks off in a couple of weeks.

This Should Ease the Fed’s Concerns

Wage growth, as measured by average weekly earnings, has now eased back to the pre-pandemic pace. Over the last three months, wage growth has run at a 3.4% annual pace, only slightly higher than it was prior to the pandemic.

While this level of wage growth is still strong, it does indicate that the labor market and the economy are not overheating. That’s important for Fed members as it eases concerns about a hot labor market pushing inflation higher. In fact, the proof is in the data. The economy has created 3.2 million jobs over the last year. Meanwhile, core PCE inflation, which is what the Fed focuses on, has slowed to 2.2% over the last three months (through August).

As we noted above, these are all positive developments, even though the market is treating good news as bad news right now. But we think that’s temporary, and we believe the equity market could be set up for a fourth quarter rally.