Markets and Events
The market had another good quarter with the S&P 500 rising 5.8% in Q3 bringing it to a very respectable 20.7% year-to-date. It was a choppy period though, with two decent pullbacks of -8.5% in late July and -4.2% in early September. But then we had a nice run from September 6-30 to finish strong. In July, we saw a major rotation from large cap growth stocks to small caps. There was a massive global computer outage caused by faulty software update by CrowdStrike. Despite declining inflation numbers, the Fed opted to not cut interest rates in late July disappoint many market observers. By early August market’s focus shifted form inflation to softening labor market. Then on August 5th we witnessed a massive spike in VIX, which is a widely followed volatility measure. It was caused among other things by a sudden unwind of carry-trade in the Japanese Yen market. Japan’s stock market plunged 12% in one day (biggest drop since 1987), although it quickly recovered and the global volatility settled back down in under two weeks. In corporate news, Starbucks CEO was replaced by Chipotle CEO Brian Niccol and Nvidia had another great quarterly report. September featured a pair of market-moving events. First, the Federal Reserve cut interest rates by half a percentage point on 9/18, which was twice as large as the expected quarter point cut. This got the animal spirits going strong. Then in the last week of the month, Chinese government unveiled a series of very substantial measures to stimulate the country’s economy and stock market. This had a large positive effect not just on Chinese market but foreign stocks overall.
There were some big developments in U.S. politics in lead-up to the election. There was an assassination attempt on Donald Trump and damning investigation into the Secret Service. At the RNC, JD Vance was unveiled as the Vice-Presidential pick. In a major shake up, President Biden dropped out of the race and endorsed Kamala Harris who quickly became de-facto democratic nominee. She selected Minnesota Governor Tim Walz as her running mate and took over the DNC in Chicago. In September we had a debate between Harris and Trump which is likely to be the only one of this cycle. Secret Service foiled another assassination attempt on President Trump at a golf course in Florida.
Outside of the U.S., elections and armed conflicts continued apace. In the UK Labor Party won the election in landslide ushering in “boring competence”. In France leftist coalition prevailed over far right but the country is now deadlocked. It also hosted the Olympic games in Paris bringing the world together for a few weeks. In Russia Wall Street Journal reporter Evan Gershkovich was sentenced to 16 years on bogus espionage charges, but was then released as part of largest East-West prisoner swap since the Cold War with 24 people involved. In a shocking maneuver, Ukraine turned the tables and invaded Russia’s Kursk region managing to capture a decent chunk of territory before being halted and holding their positions. Russia meanwhile continued to make slow but steady advances in eastern Ukraine and methodically destroying its electrical grid with missile/drone attacks. The other active conflict in the Middle East heated up with Israel escalating attacks on Hezbollah in Lebanon and pushing Iran to retaliate with a massive missile strike (which caused minimal damage).
Asset Classes
Most of the major asset classes had a good third quarter (Exhibit 1). Gold was tops with a 13% return (and 27% YTD), which is strange since it’s viewed as an inflation hedge and it has been on the decline. Small caps and international stocks also did well. Bitcoin and even corporate bonds outperform S&P 500 too. All types of bonds had a nice quarter as the interest rates have come down in anticipation of Fed’s rate-cutting campaign. As mentioned earlier, large growth to small cap rotation is evident in Nasdaq underperformance. The dollar and oil were the only negative assets on the list, which is counterintuitive given escalating tensions in the Middle East with its potential impact on oil prices.
Sectors and Stocks
Let’s take a look at which types of stocks drove the market in the last quarter (Exhibit 2). Top performers were homebuilders (rates coming down), utilities (rate and AI demand), gold miners (gold price up), real estate (rates & strong economy), and regional banks all returning 15%+ in Q3. In a major reversal, semiconductors ended up on the bottom with 6.5% drop as things corrected a bit after exuberant several quarters in that space. Wider technology sector cooled down as well. Energy stocks followed oil price down as well. So “rotation” is the common theme, which is a good development for the continued market health.
Digging a little deeper, Exhibit 3 shows the best and worst performing stocks in the S&P 500 during the quarter. The left section features top/bottom 5 names by dollar change in market value (and thus largest actual impact on the cap-weighted S&P 500 index). The usual suspects of Apple, Tesla and Meta (Facebook) were joined by stodgier Berkshire and Walmart this quarter. These five stocks accounted for 35% of the index increase. Rest of the “Magnificent 7” wound up on the negative side dragging the market lower.
The right section normalizes for the sheer company size and shows best/worst performers by percentage change in market value (as opposed to dollar change). Several small companies dominate here with returns of 40% to 50%. On the losing side, we got Moderna’s continued fall from grace after being a superstar of COVID vaccine theme and two dollar store chains imploding as their shabby business practices catch up to them.
Economy and Rates
Economic focus of market participants shifted from obsessing about inflation measures to overanalyzing labor market metrics. Sahm Rule Recession Indicator was a popular topic as it barely got to the level that has portended all modern recessions. Although the creator of this indicator made the rounds with opinion that it’s likely to be incorrect this time around. Moreover, another favorite recession indicator of “yield curve inversion” has been wrong for quite some time now. September jobs number just came out today and it looks like things are firming up after couple of soft months. Overall, the economy appears to be doing quite well despite the election polls showing it to be a major negative issue for the Democrats. I see no major warning signs other than the artificial indicators mentioned above.
Interest rates shifted downward across the entire yield curve (rates for different maturity dates). There was particularly large decline for rates on one-to-three-year bonds as the market calibrated Fed policy expectations. In fact, the rate drop happened before the 50-basis point cut on 9/18 and the rates have slightly crept up since then on strong economic data (and thus slower rate-cutting expectations). More than ever, the bond market is pricing in rate changes well before they happen leading to some interesting gyrations. Closer to home, the rate cut meant lower interest rates on Schwab cash balances (0.20% instead of 0.45%) and SWVXX money market (4.74% instead of 5.12%).
30-Year mortgage rate dropped from 6.86% on 6/30 to 6.08% on 9/30. This is a healthy development and over time it may lead to some thawing in the housing market. There is not much progress there yet as of 8/31 – the inventories remain very low and prices very high. Let’s check back in on that next quarter.