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Fourth Quarter is likely to Bring Bouts of Volatility to The US Stocks

Sports fans know that the fourth quarter is often when much of the game-deciding action occurs, and that may be the case for the stock market this year. The Federal Reserve has pushed the possibility of rate hike this year into the final quarter; the long-awaited return to positive earnings growth could be in store this quarter; economic data needs to show signs of bouncing back; and then of course there’s the U.S. election. Any or all of these could have a substantial impact on stocks. Add in what has a historical tendency for some pretty nasty October surprises, and the potential for an increase in volatility persists. We continue to believe the secular bull market which began in 2009 is ongoing, but that we’re in a mature phase likely to see some discomforting bumps along the way. Timing these pullbacks right is extremely difficult and we urge investors not to try. Instead, stick with your long-term asset allocations and view pullbacks as a chance to add to positions as needed. If the risks are causing you to lose sleep, we suggest looking into potential hedging strategies, which could cost you some money to implement, but may also keep you from making a bigger investing mistake.

Earnings take the ball

After five consecutive quarters of declining corporate earnings, the coming reporting season could prove to be important to the near-term state of the bull market. With valuations at least modestly elevated by most measures, earnings need to start to carry the weight if this bull market is to advance. Earlier this year, analysts were expecting the third quarter to see earnings growth move back into positive territory according to Bloomberg; but recent downgrades have resulted in a consensus of still-negative growth. If the so-called “beat rate” (the percentage by which companies ultimately exceed consensus expectations) is consistent with the recent past, the quarter could see earnings back in positive territory. But if earnings disappoint, the market could be vulnerable.

According to Bloomberg, analysts are expecting a 10% earnings growth rate in the fourth quarter and a robust 16% growth rate in 2017. This seems a bit on the optimistic side and leaves the market vulnerable to an increase in volatility should those expectations have to be again downgraded. The collapse in the oil market is now in the rear-view mirror, which should help to solidify both the energy and basic materials sectors’ earnings growth rates. And the stability in the dollar has also removed what had been a headwind for exporters and the industrials sector.

Economy needs a fourth quarter comeback

Economic data has been mixed over the past month. It started with soft Institute for Supply Management (ISM) readings at the beginning of September and continued with some weaker-than-expected housing data. Housing starts fell 5.8% in August and building permits dropped 2.3% according to the U.S. Census Bureau; while the National Association of Realtors reported that existing home sales fell 0.9% in August. The Chicago Fed also reported that their National Activity Index fell to -0.55 from 0.24, which has had a pretty good correlation with manufacturing activity in the past.

At this point we believe this is temporary softness brought on by a very quiet August when more folks than usual seemed to be on the sidelines; and are looking for a comeback in the fourth
quarter. Continuing historically-low initial jobless claims reading (a key leading economic indicator), the low unemployment rate, rising wages and consumer confidence, and ongoing accommodative monetary policy lead us to believe that the economy will continue to muddle through into 2017.

The Federal Reserve remains the quarterback

All of these factors play into what is likely to be the second-most asked question these days: “When will the Federal Reserve raise interest rates again?” The most recent Federal Open Market Committee (FOMC) meeting boosted expectations that a rate hike is likely before the end of the year; contingent on economic data remaining decent in the coming months. More of the FOMC’s voting body is leaning toward raising rates, as there were three dissenting votes on the decision to hold rates steady—a relatively high number indicating growing discordance among members.

This ongoing “running out the clock” strategy will likely add to the potential increase in volatility in the fourth quarter, which leads us to the most-asked question likely over the next five weeks: “How will the U.S. presidential election turn out and what will it mean?” While many investors will roll their eyes when thinking about the election, we only want to remind folks at this point that the United States has proven to be able to weather many storms and leaders of all stripes, conservative and liberal, strong and weak, popular and not, and we have little doubt the same will be the case this time around.

But it’s an “open election”—with no incumbent running—and those have historically brought choppier market action.  If the polls remain tight into the election, volatility is expected to remain elevated.

So what?

The fourth quarter is likely to bring bouts of volatility, but we believe the bull market lives on. Earnings growth is on the cusp of turning positive and the economy appears resilient enough to allow the Fed to boost rates.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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