Is a market correction coming?

Capital markets exhibited increased volatility beginning in August and continuing in September. Several negative performance days were followed by significant rallies that are keeping stocks moving in a generally positive direction. While the benchmark S&P 500 has generated relatively flat performance in September’s first half, the index produced gains in seven of the prior eight months.¹

“Markets appear concerned about signs of economic softness, and about how quicky the Federal Reserve (Fed) will respond to it with interest rate policy adjustments,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “The active question for capital markets today is now that the Fed is cutting rates, is it too late, or will its actions support the economy and continued corporate earnings growth?”

The Fed initiated a new direction in September 2024 by cutting the federal funds rate, the overnight rate banks charge each other for lending, by 0.50%. That brought the fed funds rate to a range of 4.75% to 5.00%, compared to its previous level of 5.25% to 5.50%. It was the first rate cut in more than four years, and signaled a shift from monetary tightening to a monetary easing policy.

Fed policy changes represent just one shift facing investors. The economic environment has changed, with inflation declining while the job market appears modestly weaker. Equity market leadership changed, with technology stocks experiencing a modest, third quarter retreat after driving the market’s surge since late 2022.¹

A look ahead to 2024’s closing months and beyond, economic data and monetary policy are likely to remain key indicators.

A swift recovery

2024’s first seven months saw the stock market generally move forward with only modest interruption. Through July, the S&P 500 suffered just one negative performance month. After a rocky August start, stocks quickly recovered, and markets again ended the month in positive territory, only to begin September on shaky ground.

“This is a market that’s holding in there, anticipating a series of Fed rate cuts,” says Haworth. “That is likely to be a big driver for the market, particularly as the economic focus shifts more to labor market conditions rather than inflation threats.”

Investors expressed significant concerns after two disappointing early August jobs reports. It sent stocks into a short-lived downturn. In early September, stocks once again moved down, then stabilized for a time before interest rate cuts brought about increased volatility. “While the S&P 500 is at or near new highs, other parts of the market, like small-cap stocks and the tech-heavy NASDAQ 100, are well below their all-time highs,” notes Haworth. Even at record levels, the S&P 500 has shown a greater propensity for significant price swings. Changes of 1% or more in the daily value of the S&P 500 Index were rare in 2024’s first half, but in the third quarter, the pace of 1% daily price changes rose significantly.¹

Large stocks retain their advantage

Investors have been waiting for the market’s gains, concentrated to this point on large-cap stocks, to extend to mid-cap and small-cap issues. In July, small stocks outperformed, with the Russell 2000 Small-Cap Index gaining 10.16%, compared to 1.22% for the large-cap S&P 500.¹ “Prospects of Fed rate cuts resulted in a short-term pivot into smaller stocks,” says Haworth. But the rotation to smaller-cap stocks was sidetracked in August, as the S&P 500 again outperformed mid-cap and small-cap stocks. Month-to-date through September 17, large- and small-cap stocks were in narrowly negative territory, while mid-cap stocks enjoyed a modest advantage.²

A third quarter market rotation

A major third-quarter shift occurred within the S&P 500. The once dominant technology sectors (information technology and communication services), which far outpaced other sectors in 2023 and in 2024’s first half, surrendered some gains. With signs of an easing interest rate environment, investors shifted their focus. The biggest third quarter beneficiaries were real estate and utilities stocks. Only financials and utilities stocks appear on top five lists for both the first two quarters and the third quarter.¹

Source: S&P Dow Jones Indices, LLC. As of September 17, 2024.

“Defensive issues are picking up as we’ve seen long-term interest rates come down since April,” says Haworth. “It’s a sign that a solid economy is lifting more of the market beyond technology stocks.”

During 2024’s third quarter (through September 17), three of the top five performing sectors in the first half of the year – information technology, communication services, and energy – generated negative returns. However, Haworth believes technology stocks represent a solid, long-term position. “Technology is still at the epicenter of where innovation happens in this economy,” says Haworth. “We may be in for a period of consolidation where growth rates need to settle out before tech stocks get back on track.

Key stock market drivers for the remainder of the year

What are the keys to a sustained bull market? The primary considerations that deserve attention include:

• Inflation and labor market trends and their impact on future Fed policy moves. “The attention of the Fed, which was previously centered on tempering inflation, is now focused as well on the labor market,” says Haworth. While keeping an eye on Fed interest rate expectations, investors will also closely monitor jobs reports to see if the unemployment rate continues to track higher, as it has over the past year. That could be an early signal of economic weakness.
• Consumer and business spending. “Consumers’ willingness to maintain reasonable spending growth has been an economic linchpin,” says Haworth. The labor market’s strength, including solid wage growth, contributed to that factor. The U.S. economy grew at an annualized rate of 3.0% in the second quarter, more than double its first quarter growth rate.³ “Early signals indicate that the economy is holding in there as we await third quarter GDP growth numbers,” says Haworth. That data will first be reported on October 30, 2024.
• Corporate earnings and stock valuations. Second quarter earnings grew more than 10% compared to 2nd quarter 2023 earnings. “Despite concerns of a slowing economy, earnings expectations haven’t changed,” says Haworth. “Markets anticipate continued earnings growth through the remainder of 2024 and well into 2025.”

External risks must also be considered. Current issues include the impact of global tensions highlighted by the Israel-Hamas conflict and the Russia-Ukraine war. The heated lead-up to what appears likely to be a contentious presidential election and the candidates’ policy distinctions are also beginning to draw more investor attention.

Equities still offer opportunity

While the forward view for diversified portfolios remains constructive, recent market events may offer an opportunity to reassess your financial assets relative to goals. You want to ensure that your portfolio is aligned with your long-term objectives.

“We still think it’s a great time to be invested and for those with money in cash, it represents an opportunity to put capital to work in longer-term assets,” says Eric Freedman, chief investment officer, U.S. Bank Wealth Management. He encourages investors to view markets with a long-term lens. “Timing the markets and trying to be precise on when to be in and when to be out is challenging,” says Freedman. “Markets will do things at the exact opposite time you expect them to.”

Haworth says investors may wish to consider diversifying with an equal-weighted S&P 500 exchange-traded fund. “In the current environment, a fund that puts less emphasis on the largest stocks, which is how they are represented in the traditional S&P 500, may provide some shelter from short-term volatility.” Such a fund seeks to capitalize on opportunities in what have been underperforming stocks in the index. He also suggests investors “consider putting a portion of your portfolio to work in equities in a systematic way, such as dollar-cost averaging available cash over a series of months.” This can potentially mitigate some of the risk associated with investing during a volatile market environment.

This is an important time to check in with a wealth planning professional to make sure you’re comfortable with your current investments and that your portfolio is structured in a manner consistent with your time horizon, risk appetite and long-term financial goals.

The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. Diversification and asset allocation do not guarantee returns or protect against losses. The Russell MidCap Index provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500, is designed to measure the performance of mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment. The Russell 2000 Index refers to a stock market index that measures the performance of the 2,000 smaller companies included in the Russell 3000 Index.