September was a lousy month, with the S&P 500 falling nearly 5%. Rising rates and concerns that tighter Fed policy will undercut the economy drove additional weakness in growth and small-cap investments, with the Nasdaq and Russell 2000 indexes both shedding close to 6% for the month. This capped off an overall 3% drop for the S&P 500 for the third quarter, the first quarterly loss in a year.
If history is any guide, the market’s story gets better from here, as weak third quarters have often been followed by a strong encore. Since 1990, in the 11 years when stocks fell in the third quarter, the S&P 500 rebounded with a gain in the subsequent fourth quarter nine times, averaging an impressive return of 10.6% in the final three months of the year. Small-cap stocks did even better in those years, averaging an 11.4% gain for the final quarter. 2000 and 2008 were the two instances in which the market fell in both the third and fourth quarters.
While fourth-quarter returns have been higher following third-quarter declines, the fourth quarter is traditionally a solid period for stocks, with an overall average quarterly increase of 5% going back to 1990. 2018 was the last year stocks were down for the final quarter of the year, with an average fourth-quarter gain of 9.5% from 2019-2022.
After hitting a post-pandemic high in July, the stock market has pulled back by nearly 7% through August and September. This is the third such dip in the last year, with stocks falling 7.8% in February-March and 7.3% last December. However, after the Feb-March dip, the market rallied by 7.5% in the subsequent one month, and then rallied by 7.6% in the month after the December dip, highlighting the opportunities that can come from short-term pullbacks.
We’d also point out that this latest dip has not mirrored the volatility experienced in those prior episodes. The VIX index (often referred to as the “fear index,” as it measures short-term market volatility) rose in September, but remained well below its readings during the sell-offs in March, December and October. During the last two months, there have been just eight days in which the stock market experienced a daily move greater than 1%. In contrast, there were 20 1%-plus daily moves in February and March of this year, and 25 such moves in September and October last year.
Lower volatility does not suggest market weakness can’t persist, but we think it is an indication of a more orderly pullback in which risks (potential Fed mistake, political disruptions) are more visible and are balanced by positive factors (healthy labor market, falling inflation, resilient corporate profits).
Overall, we expect markets to endure bouts of anxiety ahead, prompted by temporary uncertainties, like a government shutdown, as well as more structural challenges, like high interest-rate headwinds to the economy and stock prices. That said, we think this emerging correction in the markets will present compelling opportunities, as we think the broader uptrend in equities remains intact.