The S&P 500 climbed 8.1% (including dividends) in the third quarter and made it five months in a row of gains to bring the index’s return to +14.8% for the year as of September 30. (Carson’s Chief Market Strategist Ryan Detrick shares insight on recent market strength in A Quarter for the History Books. Now What? and Are Stocks in a Bubble?) Are we still on board with stocks being able to add to the gains in the fourth quarter (Q4)? Yes we are. There are headwinds (tariffs, policy uncertainty, labor availability, inflation), but we believe the potential tailwinds are likely to be more powerful, including debt-financed fiscal stimulus; lower rates despite inflationary pressure; and an AI boom that is having downstream effects for other areas of the market, such as utilities and industrials. Add to this momentum from the last few months plus seasonality tailwinds in Q4.
And while bonds have been boring compared to stocks, that’s part of their job and there have been recent years where they haven’t done that job very well. The Bloomberg US Aggregate Bond Index (“Agg”) was up 2.0% in the third quarter bringing its year-to-date return to 6.1% versus 3.2% for the Bloomberg 1-3 Month US Treasury Bill Index. For many investors it may be worth giving up that 3%-points for lower bond volatility, especially when the correlation between stocks and bonds has turned higher than where it typically was the prior two decades. But as the Fed continues to lower interest rates, the return outlook for Treasury bills will continue to fall, and the Agg has now beaten bills four of the last five quarters.
Takeaway: We still favor stocks over bonds. The monthly streak of S&P 500 gains will end at some point and October is historically a challenging month, but dual tailwinds from fiscal and monetary policy are hard to ignore and almost always contribute to a supportive environment for stocks while the AI boom is helping to take some of the edge off of tariff risks.
The Run for Gold Is Historic and Hasn’t Let Up
It’s hard to miss what’s on top of the Q3 leaderboard for major indexes above. The Bloomberg Gold Index returned 16.4% in the third quarter and as of the end of September is up 44.8% for the year. If the index is just flat for the fourth quarter, it would still be the best year for gold since 1979 and it wouldn’t be close. (The next best is 2007 at 31.9%.) This is not normal behavior for gold, although the strength isn’t without reason, including central back demand, a softer US dollar amid rate cuts (and rate cut expectations), higher stock-bond correlations, and geopolitical risk. This is also not the first time we’ve had this mix since 1979, so sentiment is certainly also playing a role. We added gold to our tactical models in March of 2023, not based on outsized return expectations but our view of gold’s potential effectiveness as a hedge in a changing return environment for bonds. We did think there was a chance of a run-up in gold prices under certain scenarios, but even we have been (pleasantly) surprised by the strength of the rally.
Takeaway: Don’t expect outsized price gains for the yellow metal to continue, but they don’t need to. We still like gold as a hedge, both strategically and tactically, and recent return drivers continue to be in place. For a deeper dive into our view of gold from both a tactical and strategic perspective, see Carson Global Macro Strategist Sonu Varghese’s Gold Is Shiny Enough for a Strategic Portfolio Allocation and How We Make Room for Gold in Our Strategic Allocation Portfolios.
Big Tech-Oriented Stocks Lead but Aren’t the Only Game in Town
In the third quarter, the “Magnificent 7” stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Tesla, and NVIDIA) averaged a 17.7% gain, although only four of seven outperformed the S&P 500 Index. Yes, these seven stocks now make up over 36% of the S&P 500, a level of concentration at the top that we haven’t seen, well, ever (data back to the early 70s), but we shouldn’t conflate concentrated leadership with a lack of breadth. These tech behemoths have been among the leaders in US and global stocks for a while, but year to date, all 11 sectors are also higher; the return of the small cap Russell 2000 is over 10%; and international stocks (the MSCI All Country World ex USA Index) is up 26.6%. The increased concentration of the S&P 500 is a problem, making the index more sensitive to the idiosyncratic returns of just a few stocks, but it shouldn’t be read as weakness “underneath the surface.”
For the year, as of quarter end, the Magnificent 7 have an average return of 18.4% versus the S&P 500’s 14.8% (again with only four of seven names outperforming). But the MSCI All Cap World Index, a common benchmark for globally diversified stocks (including the US), is actually outperforming the average Magnificent 7 stock this year as of the end of the quarter—only slightly but with a whole lot more diversification.
Takeaway: Diversification (not just within stocks—see gold) has been a theme of ours this year. There are extraordinary things happening in Artificial Intelligence (AI), but this is also playing out in multiple parts of the market and is not confined to the US. We continue to maintain international exposure at a benchmark-neutral weight and do have a tilt toward big tech names, both through direct sector exposure and by emphasizing US large cap stocks over mid and small.
Small Caps Respond to a Better Rate Outlook and Improving Economic Picture
Small caps surged in the third quarter, the Russell 2000 Index climbing 12.4%. Mid-caps did not get nearly the same love though, the Russell Mid-Cap Index advancing only 5.3%. The 4.3%-point outperformance versus the S&P 500 was the largest since the first quarter of 2021 and only the 4th time in the last 18 quarters that small caps have outperformed their large cap cousins. On a monthly basis, all the outperformance was in August and small caps returned to their underperforming ways in September.
There was little difference between small cap value and growth during the quarter, the Russell 2000 Growth and Value Indexes were separated by less than 0.5%-points, unlike large caps where it was over 5%-points. Small cap interest was broad based and there has been some rotation back to small caps amid a better rate outlook (small caps depend more heavily on borrowing) and an improving economic picture.
Takeaway: We’ve seen brief small-cap price surges relative to large caps several times over the last decade but are still in “show me” mode. The Russell 2000 has underperformed the S&P 500 every year since 2017 save one (2020, and it was a difference of less than 2%-points). At some point valuation differences do become large enough to become if not compelling at least interesting from a strategic perspective, but we don’t think a later cycle environment in which the rewards for scale in the AI infrastructure rollout is the time to expect a reversal, but it’s something to monitor.
The Big Picture
We think it is fair to say that we are in a “later” cycle environment, but later cycle environments can last a long time and there are some strong forces in play that we believe are likely to extend the cycle. Yes, we call it a “cycle” for a reason. There is inevitably a downturn at some point. We can even see some of the forces starting to build that may contribute to that downturn eventually, but “starting” is the operative word. Q3 was a strong quarter and we are unlikely to match it, but what drove the market strength is still building in our view and the amount of uncertainty has declined, even if we still find ourselves in some ways in “uncharted waters.” We continue to favor stocks over bonds while looking for sources of diversification both within and between asset classes.
For more content by Barry Gilbert, VP, Asset Allocation Strategist click here.
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