The outlook for indices in Q4

After a volatile year so far for equities, what does the final quarter hold?

Trader
Source: Bloomberg

2018 has been a volatile year for stock markets, and one where the divergences between markets in performance terms has become much more apparent.

The strength in US indices has been remarkable, and looks set to continue, thanks to an acceleration in wage growth and much stronger economic fundamentals overall.

However, while some markets have soared, others have lagged behind, as the table below shows:

Index

% return YTD

S&P 500 8%
Nasdaq 100 15.5%
FTSE 100 -5%
DAX -7.2%
Nikkei 225 -0.68%

But all indices will see some seasonality tailwinds once we reach the final quarter of the year. The MSCI world index has two strong periods each year, February – April, and October – December. This year, the first traditionally strong period saw a flat performance; the ongoing recovery in stocks augurs well for the second half.

The first place to look for this would be the outperformers, i.e. the US. First, the S&P 500. It too enjoys a good period in February – April, and then October December, as the below chart shows:

But the Nasdaq 100 is also the other prime candidate for outperformance as the year moves to its close:

US markets continue to be the engine room of the global equity markets, but fortunately for investors they have the economic and corporate fundamentals behind them.

Unemployment claims continue to fall, with no sign of the trend changing direction. Claims tend to rise at least seven months before the next recession:

New home sales close to the ten-year high of November, and while slightly weaker in July, the high for this reading comes at least 11 months before the next recession:

Goldman Sachs has pointed out that the risk of a stock market decline remains low while the US economy continues to expand. Indeed, the chance of a 10% decline in the market (a normal correction that can occur in any year) is just 4%:

Away from the US, gross domestic product (GDP) growth in the eurozone remains solid, if unspectacular:

While European markets have been left behind this year, the final quarter of the year is also a strong one historically:

Turning to corporate data, again it is the US that should keep driving this equity train forward. Quarterly earnings per share (EPS) grew by 27% over the year in the second quarter (Q2), while the trailing 12-month figure was up 21%.

Since 2010, growth in profit has accounted for 92% of earnings growth, compared to just 8% in share buybacks. This is an earnings-driven market, not once ‘artificially’ pushed higher by share buybacks, as some like to claim.

Earnings in fact have risen by 41% since the second quarter of 2016, versus a 30% increase in the S&P 500. This market is being driven by fundamentals, not by quantitative easing (QE) or other supposed ‘market manipulation’. This bull market, especially in the US, has firm foundations.

We should expect continued volatility along the way, as we have seen in European markets (where, for example, the DAX has yet to show any inclination to return to all-time highs), and in emerging markets, which have suffered their biggest rout in years of late, but the overall picture remains healthy.

Stock markets, of course, go up most of the time. Indeed, the probability of the S&P 500 going up on any given trading day is around 55%. Suggesting that the current bull market will continue is not a particularly brave call, or a contrarian one.

The final quarter of the calendar year traditionally sees strong returns, even before the fabled ‘Santa rally’ gets underway before Christmas. Trade wars, Brexit and a host other problems may dog the rally, but historical performance and fundamentals point to further appreciation in equity prices.

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