Why Stocks May Plunge in 3Q after Record Run in First Half

The S&P 500’s spectacular 17% gain in the first half marks one of the strongest performances during that period since 1945. But stock investors should brace for a volatile second half of 2019, despite rising optimism about a trade deal on the heels of U.S. President Trump’s meeting with President Xi Jinping at the G-20 summit, according to Sam Stovall, chief investment strategist at CFRA.

“The third quarter is notorious for delivering the weakest average price return, while recording the deepest decline and greatest volatility,” Stovall wrote in a note. Since 1990, he says, "Not only did the S&P 500 record an average decline in Q3, but so did four of its cyclical sectors: communication services, consumer discretionary, industrials and materials, with consumer discretionary and materials posting sub-50% frequencies of quarterly price gains."

What it Means for Investors

Since World War II, stocks in the third quarter have risen only 59% of the time for an average gain of 0.5%. The third quarter also has seen the steepest decline, falling by more than 26% at their lowest point, according to CFRA. By comparison, stocks have fallen by about 12% on average at their steepest point in first quarters during that period.

Quarters one and two show a marked improvement, with average price increases of 2.3% and 1.9%, respectively. But it is in the fourth quarter where stocks have performed best, up 78% of the time for an average increase of 3.8%, suggesting there is some light at the end of the third-quarter tunnel.

Stovall says stocks are likely to face major headwinds. Despite the positive tone coming out of the Trump–Xi talks, it's unclear whether the U.S. and China will reach a formal trade deal. Some of the most fundamental issues, such as those surrounding intellectual property rights, remain unresolved and tariffs remain in place. “Trade remains the dark cloud,” wrote Stovall. 

A lot of optimism is riding on expectations of rate cuts from the Fed, which if fulfilled, could mirror what happened in 1995 when the Fed abandoned rate hikes early in the year before eventually cutting rates. The S&P 500 jumped 34% that year. If those rate cuts don’t happen, stocks could plunge.

Further, Wall Street consensus estimates are calling for an EPS recession, with earnings in the second and third quarters forecast to decline. “Three out of every four EPS recessions since WWII preceded economic recessions,” wrote Stovall.

Despite these forces, Stovall is optimistic. He believes that the current economic expansion, which in July will become the longest in history, still has legs and will push stocks higher. Investors will have to endure the historically volatile third quarter in order to get there. His 12-month price target for the S&P 500 is 3100, implying a 4% upside from today's levels. “We think this expansion has further to run, as well as the S&P 500,” he wrote. “We just don’t think stocks will do so in a straight line.”

Looking Ahead

Some market watchers are even more optimistic. Veteran market strategist Ed Yardeni also has an S&P 500 price target of 3100, but sees that occurring by the end of the year rather than over the next 12 months. His optimism is based on the premise that Trump won’t do anything to the economy that would harm his chances of winning next year’s presidential election, according to Barron’s.