Mullaney on the Markets | October Harvest Yields Best Returns for Equity Investors Since 2015

By Michael Mullaney | Director of Global Markets Research
Published November 2022

Earnings, Growth Expectations, Hope for Easier Rate Policy Send Stocks Higher

The S&P 500 rebounded in October with a return of +8.10%, the strongest return for the month of October since 2015 and helped alleviate the shellacking the market took in September.

There were four themes that helped drive prices higher during the month: 1) the prospect of a “pause/pivot” in rate hikes by the Federal Reserve as the Bank of Canada, the Reserve Bank of Australia and the European Central Bank all signaled a “wait and see” approach to future hikes to which the Fed responded with a “trial balloon” story of its own on the subject matter that was “planted” in the Wall St. Journal. 2) a resilient Q3 earnings season with 278 of the S&P 500 companies reporting sales that averaged +1.6% higher than expectations and earnings with a +2.2% upside surprise. 3) the increased likelihood of a Republican sweep in the mid-term elections which many investors believe would lead to a “friendlier” business environment. 4) an above consensus rebound for Q3 GDP to +2.6%.

Year-to-date the S&P remains “in the red” with a return of -17.70%.

All Sectors Advance, Energy Sector Helped by Higher Crude Oil, Natural Gas Prices 

All eleven sectors that comprise the S&P 500 posted gains in October, led by three cyclical sectors: Energy (+24.96%), Industrials (+13.92%) and Financials (+12.00%). Energy benefited from an 8.9% increase in oil prices during the month, Industrials from the trend towards onshoring of U.S. manufacturing and Financials from a jump in interest rates.

Laggards for October were a combination of long duration sectors (Communication Services: +0.14%), (Consumer Discretionary: +0.23%) and bond surrogates (Real Estate: +2.05%) all responding to an average increase of twenty-three basis-points along the Treasury yield curve that led to a -1.30% loss for the Bloomberg Aggregate Bond Index.

Year-to-date Energy continues as the only sector with a positive rate of return at +68.05% with crude oil up 12.39% year-to-date and natural gas by +37.16%.

The sectors that are lagging for the year are identical to those that did so during the month: Communication Services (-38.96%), Consumer Discretionary (-29.73%) and Real Estate (-27.47%) all succumbing to the weight of an average increase in interest rates of 288 basis points across the yield curve through October. Technology, another long-duration sector, also suffered with a loss of -26.08%.

Defensive Stocks Do Well

Though the stock market jumped higher during the month, stocks with more defensive characteristics generally performed better than those considered to be riskier in nature, as high-quality stocks (those rated “B+” or higher by Standard & Poor’s) returned +8.95% while those rated “B” or lower returned +7.70% and the lowest beta quintile of the S&P 500 beat the highest beta quintile by 1.13%. One exception to this trend was in small versus large-cap stocks where the Russell 2000 Index returned +11.01% during the month to the +8.02% posted by the Russell 1000 Index of large-cap stocks, though the S&P 600 Index of small-cap stocks, which only includes companies with positive earnings, outperformed the Russell 2000 Index (which includes companies with negative EPS) by 1.36%.

Year-to-date high quality and low beta stocks are down substantially less than low quality and high beta stocks, indicative of a “risk-off” trading environment, though like what happened during the month, the Russell 2000 Index of small-cap stocks pulled ahead of the Russell 1000 Index of large-cap stocks, -16.86% to -18.54%.

In terms of style, Value outperformed Growth by an average of +3.03% during October based upon the return differences between the Russell 1000, the Russell Mid-Cap and the Russell 2000 Growth and Value indices. The return difference was most pronounced in the large-cap space, with the Russell 1000 Value Index returning +10.25% to the + 5.84% recorded by the Russell 1000 Growth Index. The Russell 1000 Growth had a big negative contribution from two stocks, Amazon, which fell by -9.35% during the month and Tesla, which dropped by -14.22%. Together the two stocks account for 9.18% of the Russell 1000 Growth Index.

Year-to-date Value maintains a commanding lead over Growth at +13.97% when averaged across the small, mid, and large-capitalization ranges of the respective Russell benchmarks.

Strong Dollar Hurts Non-U.S. Equities

Returns for non-U.S. stocks underperformed during the month. In local currency terms the MSCI EAFE Index of developed market stocks lagged the S&P 500 in local currencies (+5.34%) and in dollars (+5.39%). The MSCI EM Index fared worse, dropping by -2.61% in local currencies and by -3.09% in $USD terms as emerging market currencies fell by -0.91% during the month versus the dollar according to the MSCI Emerging Markets Currency Index.

For the year results from the international bourses are more mixed, with EAFE ahead of the S&P 500 in local currencies with a return of -9.48% but lagging in $USD terms at -22.81%. Emerging markets were less fortunate as the MSCI EM Index fell by -22.54% in local currencies and by -29.15% in dollar terms through October. As one can see, the strong dollar has played a significant role in international returns in $USD terms with the Bloomberg Dollar Spot Index up +13.7% versus a basket of ten major currencies and the MSCI Emerging Markets Currency Index down by -9.06% versus the dollar.

The Fed’s Campaign to Contain Inflation 

On November 2nd, the Federal Reserve continued its quest to eradicate inflation by raising the Fed Funds rate by 75-basis points for a fourth consecutive time, the next step in the most aggressive tightening campaign by the Fed since Paul Volcker’s in 1980. With 30 minutes to spare before Chairman Powell began his Q&A session, the statement accompanying the rate decision was scrutinized and ultimately taken to be somewhat dovish with the inclusion of the verbiage: “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”, with stocks and bonds rallying as investors interpreted the statement as a hint that a pause in rate hikes might be in the offing.

The enthusiasm was short-lived however, as during the Q&A session that followed Powell dropped what was considered to be a couple of bombs: “And incoming data since our last meeting suggests that the ultimate level of interest rates will be higher than previously expected.”, i.e. a higher terminal Fed Funds rate than currently priced into the market, and “Let me say this. It is very premature to be thinking about pausing. So people, when they hear lags, they think about a pause. It’s very premature, in my view, to think about or be talking about pausing our rate hikes.,” i.e., higher for longer interest rates.

After the remarks the price of the 10-Year Treasury Bond promptly dropped by over one point and the S&P 500 ended the day down by -2.50%, the conclusion being that the final level of rates supersedes the cadence of future rate hikes in terms of what is important for investors.

At month-end the futures market had been pricing in a May ’23 peak in Fed Funds at 4.96% with subsequent rate cuts leaving the funds rate at 4.51% by January ’24. After Chairman Powell’s Q&A session, the peak in Fed Funds shifted to 5.17% in June ’23 with subsequent rate cuts leaving the funds rate at 4.81% by January ’24. So much for trial balloons.

While a handful of leading economic indicators are flashing warning signs of a future recession, the notion of its imminent arrival seems misguided as employment remains robust, and while not spectacular, consumer spending is steady and solid. The Atlanta Fed’s own GDPNow model is currently forecasting a Q4 GDP print that matches that of Q3 at +2.6%, and the National Bureau of Economic Research (NBER – the official arbiter of recessions) favorite “quick & dirty” indicator, the average of GDP and GDI (Gross Domestic Income) remains in positive expansionary territory. While an expanding economy is a positive for individuals, families, and corporations, it is a headwind to the Fed’s inflation goals.

Historic Performance of Equities During Mid-term Election Years

Lastly, in the nineteen mid-term election years since WWII, post-elections the S&P has gone on to post gains for the final two months of the year 73.7% of the time with an average return of +6.53%, versus an average loss of -3.79% in the years when the returns were down post-election. In the 12-months following mid-term elections since WWII, the S&P has gone on to post gains 100% of the time with an average return of +15.42% and a median gain of +15.0%.


Terms and Definitions:

[1] The federal funds rate is the target interest rate set by the FOMC. This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. The FOMC sets a target federal funds rate eight times a year, based on prevailing economic conditions.

[2] CPI: The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

[3] The S&P 500 Index is a registered trademark of the McGraw-Hill Companies, Inc. and is an unmanaged Index of the common stocks of 500 widely held U.S. companies.

[4] Beta is a measure of a stock’s volatility in relation to the overall market. By definition, the market, such as the S&P 500 Index, has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market.

[5] The 10-year Treasury is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance.

[6] Basis points refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument. The relationship between percentage changes and basis points can be summarized as follows: 1% change = 100 basis points and 0.01% = 1 basis point.

[7] The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index.

[8] The Russell 1000® Index is a stock market index that tracks the highest-ranking 1,000 stocks in the Russell 3000 Index, which represent about 93% of the total market capitalization of that index.

[9] The Russell 1000® Value Index contains stocks included in the Russell 1000® Index displaying low price-to-book ratios and low forecasted growth values.

[10] The Russell 1000® Growth Index measures the performance of the large cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales per share historical growth (5 years)

[11] Russell 2000® Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

[12] The Russell 2000® Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.

[13] The Russell Mid-cap® Value Index contains stocks included in the Russell Midcap® Index displaying low price-to-book ratios and low forecasted growth values.

[14] The Russell Mid-Cap® Growth Index measures the performance of the midcap growth segment of the US equity universe. It includes those Russell Midcap Index companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (2 year) growth and higher sales-per-share historical growth (5 years).

[15] MSCI EAFE Index: A free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada

[16] DXY Index is the U.S. Dollar Index (USDX, DXY, DX, or, informally, the “Dixie”) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies,[1] often referred to as a basket of U.S. trade partners’ currencies.

[17] MSCI EM (Emerging Markets) Index:  Captures large and mid cap representation across emerging markets countries covering approximately 85% of the free float-adjusted market capitalization in each country.

[18] MSCI Global Currency Indices measure the total return of currencies of countries in a regional or composite MSCI equity index, weighted by their country weights. The total return reflects the currency appreciation/depreciation of the currencies included the currency index relative to the home currency and interest accruing from holding the currencies.

[19] MSCI EM Currency Index in USD measures the total return of 25 emerging market currencies relative to the US Dollar, where the weight of each currency is equal to its country weight in the MSCI Emerging Markets Index.

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