What To Expect in the Stock Market in Q4

Stocks defied the odds in September, ticking up to trade at record highs despite the month’s reputation as a notoriously rough patch for equities. Thanks to September’s gains, the S&P 500 has posted its strongest first three quarters of the 21st century. 

Equities were given a lift this month by the Federal Reserve, which joined the ranks of global central banks easing monetary policy when it cut interest rates—by 50 basis points—for the first time in four years. The cut, according to officials, was a preemptive step to support the labor market, which data suggests is cooling but not falling apart.

The fourth quarter is historically a strong one for stocks, and analysts—despite noting the likelihood of elevated volatility—are broadly optimistic about the outlook. 

The Labor Market in Focus

As in the third quarter, the economy is likely to be top of mind for investors throughout the fourth quarter. Wall Street will especially be looking at labor market data for evidence of deterioration that would worry the Fed. 

Initial unemployment claims will be a key data point to keep an eye on, according to analysts at Russell Investments. Claims data, which is released weekly, has less of a lag than other labor market data. “These will provide the clearest real-time guidance on whether the U.S. economy is rebalancing or drifting towards recession,” they say.

Initial claims sustainably above 260,000 per week would be a red flag, in their view. The four-week average as of late September stood at about 225,000.

Fed officials, in their most recent economic projections, penciled in another half-percentage-point cut from interest rates this year. An uptick in unemployment coupled with job losses could spur the Fed into more aggressive action at one of its two policy meetings. That would bring interest rates more in line with market expectations, but would likely also spook investors and do some damage to stock portfolios.

Soft Landing Seen Good for Stocks

The consensus on Wall Street is that the Fed is likely on track to achieve the soft landing it’s been chasing for years, which bodes well for stocks. 

As of late September, the Atlanta Fed’s GDPNow calculator estimated the U.S. economy grew at an annual rate of 3.1% in the third quarter. 

Six of the last 10 rate-cutting cycles coincided with recessions. In those instances, the S&P 500 fell on average in the year after the first cut. In the four cycles that coincided with soft landings, the average return was in the high teens.

Conventional wisdom says that small-cap stocks should benefit most from interest-rate cuts since they are more likely to have floating-rate debt. However, BlackRock analysts found that large caps have outperformed small caps during rate-cutting cycles since 1984, and that the outperformance is most pronounced outside of recessions. 

At the sector level, healthcare and consumer staples have performed the best during rate cuts, while communication services and tech have been the worst performers. 

The S&P 500, excluding the Magnificent Seven, in the second quarter grew aggregate earnings for the first time since 2022. Third-quarter results, which companies will begin reporting in mid-October, are expected to show the profitability gap between tech mega caps and the rest of the market is continuing to narrow. 

The Mag 7, meanwhile, faces the challenge of convincing Wall Street that their massive investments in artificial intelligence (AI) will pay off. They struggled to do so over the summer, sparking selloffs that the group has yet to fully rebound from. These stocks could continue to face pressure if their earnings fail to live up to Wall Street’s lofty expectations. 

Politics Could Stoke Volatility

Political developments are likely to amplify stock volatility through the rest of the year, even if they don’t fundamentally change the economic or business outlook. 

The presidential election in November is one such event that could deliver Wall Street a short-term shock. BlackRock analysis found that, more often than not, the market’s knee-jerk reaction to a presidential election is not indicative of its performance over the next year. Still, the presidential candidates have staked out positions on tariffs and corporate taxes that, if enacted, would surely change the outlook for U.S. businesses. 

Conflicts in the Middle East and Ukraine could also keep the stock market on edge as long as they threaten to disrupt global trade or roil energy markets. 

Experts note, however, that volatility is a two-way street that can provide canny investors with opportunities to buy stocks at attractive valuations. Heightened volatility can also turbocharge short-term returns. Since 1990, the S&P 500 has returned 16% on average in the six months after the Cboe Volatility Index has risen to 29 or higher, compared with an average return of 5% in less volatile periods.