In a year of wild market swings, the third quarter of 2022 was a time when events took a truly extraordinary turn.
As the Federal Reserve ratcheted up its monetary policy tightening to tame the worst inflation in decades, U.S. Treasury yields shot to their highest levels in more than a decade and stocks reversed a summer rally to plumb fresh depths.
The S&P 500 is down nearly 24% year-to-date, while yields on the benchmark 10 year Treasury note, which move inversely to bond prices, recently hit their highest level since 2008.
Outside the United States, the soaring dollar spurred big declines in global currencies, pushing Japan to support the yen for the first time in years. A slump in British government bond prices, meanwhile, forced the Bank of England to carry out temporary purchases of long-dated gilts.
Many investors are looking to the next three months with trepidation, betting the selloff in U.S. stocks will continue until there are signs the Fed is winning its battle against inflation.
Yet the last quarter of the year has often been a beneficial time for U.S. equities, spurring hopes that markets may have already seen the worst of the selloff.
PASS THE DIP
The strategy of buying stock market dips yielded rich rewards for investors in the past but failed badly in 2022: the S&P 500 has rallied by 6% or more four times this year and went on to make a fresh low in each instance.
The third quarter saw the index rise by nearly 14% before reversing to make a fresh two-year low in September after investors recalibrated their expectations for even more aggressive Fed tightening.
LOOK OUT BELOW?
With several big Wall Street banks expecting the benchmark index to end the year below current levels - Bank of America and Goldman Sachs both recently published year-end targets of 3,600 - the outlook for dip-buying remains murky.
In addition, the current bear market, which has so far lasted 268 days and notched a peak-to-trough decline of about 24%, is still relatively short and shallow compared with past drops. Since 1950, the average bear market has lasted 391 days with an average peak-to-trough drop of 35.6%, according to Yardeni Research.
LOOK TO BONDS
Though equities have been volatile, the gyrations in bond markets have been comparatively worse.
The ICE BofAML U.S. Bond Market Option Volatility Estimate Index shot to its highest level since March 2020 as the ICE BofA US Treasury index is on track for its biggest annual drop on record.
By comparison, the Cboe Volatility Index - the so-called Wall Street “fear gauge” - has failed to scale its March peak.
Some investors believe stock turbulence will continue until bond markets calm down.
“I think there is a good scenario where once we get through the bond market violence, we get to a more tradable bottom (for stocks),” said Michael Purves, chief executive at Tallbacken Capital Advisors in New York.
… AND THE DOLLAR
Soaring U.S. interest rates, a relatively robust American economy and investors’ reach for safe haven amidst a rise in financial market volatility has boosted the U.S. dollar – to the detriment of other global currencies.
The greenback is up about 7% for the quarter against a basket of currencies and stands near its highest level since May 2002. The dollar’s strength has the Bank of Japan to shore up the yen through interventions while also presenting an earnings headwind for U.S. corporates.
“Market risk-takers are grappling with the double-barreled threat of persistent dollar strength and dramatically higher interest rates,” Jack Ablin, chief investment officer at Cresset Capital, said in a note.
EARNINGS TEST
Third quarter earnings may present another obstacle to markets, as companies factor in everything from dollar-fueled currency headwinds to supply chain issues.
Analysts have become more downbeat on third quarter profit growth, with consensus estimates falling to 4.6% from 7.2% in early August, according to Refinitiv IBES. So far, that is only slightly worse than the median 2.2 percentage point decline ahead of reporting periods historically, yet warnings from companies such as FedEX and Ford have hinted at the possibility of more pain to come.
‘TIS THE SEASON
The calendar may offer weary stock investors some hope.
The fourth quarter is historically the best period for returns for major U.S. stock indexes, with the S&P 500 averaging a 4.2% gain since 1949, according to the Stock Trader’s Almanac.
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