Quarterly Investment Guide

The market is surging, but top experts warn there are risks that could derail stocks in Q4  

Key Points
  • The S&P is up 7.45 percent year-to-date and hit a record high Tuesday morning to break above 2,900. It’s increased 12.43 percent since Feb. 8, when the market hit its low for the year.
  • Nasdaq hit a historic high, breaking 8,000 for the first time on Monday.
  • But market experts say rising interest rates, geopolitics and slower earnings growth could derail the stock market in the fourth quarter of 2018.

Earlier this year, many top investors expected volatility to increase and stock market growth to slow, and while the market did tumble in late January, for the most part U.S. equities have been on another tear. The S&P 500 is up 7.45 percent year-to-date, and it's increased 12.43 percent since Feb. 8, when the market hit its low for the year.

Can these good gains continue into the fourth quarter? According to some experts, rising interest rates, geopolitics and slower earnings growth, among other things, could cause equity market growth to slow and even end America's almost 10-year bull run.

"We're in an uncomfortable bull market," said Sebastian Page, a Baltimore-based fund manager who oversees $300 billion of investments as T. Rowe Price's head of global multi-asset allocation.

Stocks have done well so far because of strong corporate earnings, due in part to tax reform and a recovery in energy prices, but that earnings growth, which has been in the 20 percent range, could decline dramatically in the latter part of the year, he said. He wouldn't be surprised to see earnings growth in the high single digits.

Why the decline? Because the global economy, which has been growing in unison for the last year, is decoupling again.

"Global growth is much less synchronized, the banking sector in Europe is quite fragile, and the dollar is appreciating, which doesn't help," he said. Since February the U.S. dollar has climbed by about 5.8 percent against a basket of other currencies.

Investing in the record bull market

Other experts aren't as worried as Page may be, but there are still plenty of risks on the horizon. Mark Zandi, chief economist with Moody's Analytics, thinks the U.S. economy will remain strong for the next 12 to 18 months and that unemployment should continue to decline.

However, stock markets, which characterizes as "middling" this year, will be choppy. Tax cuts are already priced in, he said, while investors will have to grapple with rising labor costs and higher interest rates. "The best days of the bull market are behind us," he said.

Richard Weiss, who oversees $40 billion in assets as the chief investment officer of multi-asset strategies for American Century Investments, is also taking a more cautious approach.

In the target-date funds he oversees, including the firm's One Choice portfolios, he's neutral stocks for investors with long time horizons of 20 years or more. That means he's not overweight or underweight in those portfolios, but he is underweight equities with his more conservative investors.

He thinks stock gains could continue, but he too wants to be more careful.

"It's hard to bet against this market, but then again, when you can't see any problems, that's usually when the market gets nailed. So we want to be careful," he said.

Page, Zandi and Weiss all think that stock performance could be so-so in the fourth quarter, but they also point to several things that could have a more significant impact on equities this year and into next.

Trade war escalating

The biggest risk Zandi sees to this bull run is a global trade war. While the United States has put tariffs on just $100 billion worth of goods so far this year — a small amount, considering the country imports $2.5 trillion of goods every year — if Trump continues to impose tariffs on China, Mexico, Canada, the EU and others, then markets would take a big hit.

A trade deal struck on Monday between Mexico and the United States that paved the way to replace NAFTA may alleviate some of those fears, but U.S. tariffs on Mexico are still in place.

Market has legs for at least another six or seven years, says strategist

A trade war, he said, is bad for business. Goods become more expensive for U.S. consumers to buy, which then eats into people's purchasing power. If consumers spend less at the store, earnings growth declines. As well, if other countries put tariffs on their own imports, and people in those countries buy homemade goods, then the global profits of U.S. companies could drop. All of that will have an impact on earnings and, therefore, stock prices.

More from Quarterly Investment Guide:

US-Mexico trade deal buoys auto stocks

Nasdaq hits 8,000

"It's going to hurt jobs and unemployment," said Zandi. "Anything that hurts trade, hurts the economy, which hurts earnings."

Rates rising too quickly

Since December 2015, the Federal Reserve has raised its overnight rate seven times, from 0.25 percent to 2 percent. While the Fed has taken a measured approach to rate hikes, said Page, one big risk is that they move too quickly from here.

The Fed has set the stage for a September hike and Fed Chairman Jerome Powell has pointed to two more interest-rate hikes before the end of 2018.

"History says that to top things over into a recession, all the Fed needs to do is raise rates too fast," he said.

While he doesn't see that as an imminent threat, if inflation rises, which could happen if oil spikes or if the labor market tightens too quickly that wages rise, then the Fed may have to increase interest rates faster than expected.

Weiss adds that even the perception of increasing rate hikes could send markets tumbling.

"If we get a scare that raises fears of more precipitous interest-rate increases, then that could be a sucker punch for the market in the fourth quarter," he said. "I'm not betting on that happening, but it's always a potential derailer."

Extreme valuations

While many investors have made a lot of money during this bull run, one consequence of stocks moving up is that valuations are now relatively high. On a price-to-earnings basis, the S&P 500 is trading at about 17 times forward earnings, according to S&P Capital IQ, and while that's trading below the 19 times forward earnings it was at in January, it's still high, said Zandi.

As well, with the market being driven by a handful of high-growth tech stocks, including Facebook and Amazon — all with high valuations — if investors get spooked, stocks could fall far more than if the market were less expensive.

"The market is more vulnerable to a significant correction if sentiment shifts or if we do see a trade war escalate," he said.

Potential impeachment

The wild card in all of this is President Donald Trump. So far, the many issues surrounding him haven't impacted the markets, not even possible jail time for Paul Manafort and Michael Cohen, who were at one time two of his closest associates.

But Q4 could spin out of control if either he loses the House and Senate in November or if the possibility increases of him leaving office in some way, said Weiss. It's an unlikely scenario, but it's not as out of the question today as it was a few months ago.

Weiss said that, for the most part, the current government has been good to markets — it's pro-growth, and the tax cuts helped — but "a change of any kind that undermines the White House and Congress could cause some short-term hiccups," he said.

Page agrees. If the government's growth agenda is put in jeopardy, then that will "definitely matter" to markets, he said.

Zandi, though, sees a more sinister scenario unfolding, in which Trump doesn't go quietly. If he puts up a fight on the way out, then markets would certainty spiral out of control.

"It depends on what he decides to do, how he responds and how everyone else responds," he said. "If he fades away, then no big deal. In fact, the transition could even be positive for markets. But there are other directions he could take it, many of which are pretty messy."