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Bull market heads into fourth quarter at highs, but faces hurdles in rising rates and valuations

Key Points
  • The S&P 500 hit another record high last week and is ahead by nearly 10 percent for the year, confirming its longer-term uptrend through August and now most of September — historically challenging months.
  • But heightened sensitivity to global market conditions and the valuation of equities compared with bonds are pressure points that could weigh on stocks in the fourth quarter or complicate the picture in early 2019.
  • The market during this economic cycle has not tolerated stocks much above this valuation with bond yields in the 3 percent area.
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If the stock market were football, then entering the fourth quarter it would be the bulls' game to lose, with most of the pregame question marks about their stamina and halftime worries over roster depth answered assertively — in the form of a big lead and few obvious weaknesses.

The hit another record high last week and is ahead by nearly 10 percent for the year, confirming its longer-term uptrend through August and now most of September — historically challenging months. It was joined in record airspace by the Dow industrials, a sign that the trade frictions between the U.S. and China have been more a psychological weight than direct hit on equity values.

New record highs are more bullish for the market's outlook than a warning, historically, though they do furnish a handy chance to assess the broader backdrop.

Volatility, credit signals, investor sentiment and corporate-profit trends all tilt toward a continued sturdy market. But at these higher prices, heightened sensitivity to global market conditions and the valuation of equities compared to bonds are pressure points that could cut into the bulls' lead in the fourth quarter or complicate the picture in early 2019.

Credit markets are firmly supportive of the equity strength, with high-yield spreads compressing to nearly their tightest levels of the year as Treasury yields lifted toward their highs. And projected S&P 500 earnings have held up quite well so far in aggregate, expanding the fundamental cushion under the market.

The Cboe Volatility Index has retreated below 12, not far above the floor of its long-term range — a sign of low financial stress and lots of offsetting up-and-down action among sectors keeping the tape stable.

The push-pull of strong and weak groups of stocks remains a feature of this market phase. Skeptics deride this as a "narrow" and therefore vulnerable market. But the majority of stocks are participating in the rally. It's perhaps more accurate to characterize this market as selective and rotational rather than inclusive and propulsive.

A turn toward defensive-sector leadership over the summer — with utilities, health care and consumer staples outperforming — kept the bears from cutting into the bulls' lead by much.

Time for global stocks over US?

A question now is whether this pattern is giving way to another run by more cyclical groups — which would include financials, and could very well mean the U.S. would underperform beaten-down foreign markets.

Deutsche Bank strategist Binky Chadha is calling for such a shift: "The US equity rally on the latest tariff announcement, the rotation in favor of cyclical sectors, and the rally across global equities, all suggest a lot was already priced in… Flows and positioning are supportive of both a cyclical rotation within the US and the outperformance of global over US equities."

It all fits with the apparent positioning of the big money. The monthly Bank of America Merrill Lynch global fund manager survey released last week showed cash holdings of institutions at an 18-month high and allocation to emerging markets at a record low relative to the U.S.

This helps explain the sharp risk-asset rally last week: stocks up, led by emerging markets; U.S. dollar down; commodities up; Treasury yields up across all maturities, carrying bank stocks with them.

But this dynamic also highlights the conditions this rally seems to depend on — and suggests that reversals could thwart it.

If the rebound in emerging markets and slide in the dollar prove to be fleeting reflex moves from overstretched levels, would the S&P 500 stall? And financial stocks were asleep for months until Treasury yields clearly broke out of their sideways range — so would a settling back of yields drag the stocks with them?

Rising rates

And if bond yields do stay up here, with the 10-year above 3 percent and the Fed about to lift the overnight rate in a few days, does that put a firmer valuation ceiling on stocks?

The S&P 500 has climbed back to 17 times forecast earnings for the next 12 months. That's below the 18.5 times at the peak in January, but of course in January the market was pricing in three or four straight quarters of 20 percent profit growth — which will not nearly repeat next year.

The market during this economic cycle has not tolerated stocks much above this valuation with bond yields in this area. As impressive as the market's recovery has been, the S&P 500 is only up about 2 percent in the past eight months since hitting the January valuation extreme, after all.

In the '90s and early 2000s, of course, stocks were almost always valued much more richly than now against bonds. It's unclear whether this relationship has been reset given the low absolute yield levels (or if it ever had any real utility as an indicator).

But with the trailing price-earnings multiple on the median stock even higher than it was at the year-2000 peak, it's fair to say that the market is not priced to withstand serious concerns about profit margins or the sustainability of this business cycle.

When valuation gets stretched, the market sometimes grabs at any excuses to pull back, such as incremental tariff announcements, even if the trade issue isn't decisive for this economy or bull market.

Those may not be the issue for today or tomorrow. As noted here last week, the market action and fundamental cues hint that "time is running out for the fundamentals to fall apart in time to pressure the market much this year."

Markets that feed off excess anxiety and defensiveness at some point run out of it and risk tripping into complacency. It's hard to make the case this point has been reached yet. But as the market climbed last week, did it seem that a good number of those warning of trade war risks for months suddenly decided it was "priced in" already?

That kind of mood shift — and any building consensus that a straight-line fourth-quarter rally is a lock — are the things to watch out for as the game enters the fourth quarter.