OREANDA-NEWS. October 05, 2016. The S&P 500 ended the third quarter with a gain of 3.3 percent. It was the best quarter of the year, and leaves the index higher by 6.1 percent. Far and away the best performing sector was technology, with a gain in excess of 10 percent. Industrials and financial stocks had gains of 4.0 percent. At the opposite end telecom, utilities and consumer staples stocks suffered losses. It’s worth noting that all of the third quarter’s gains for the broader index came in July. Stocks were fractionally lower in both August and September. Even technology, the only sector to post a positive return in each of the quarter’s three months, enjoyed 70 percent of its gains in July.

It was a quarter that began with expectations of accelerating growth after a sluggish first half, accompanied by another step toward policy normalization by the Federal Reserve. Economically sensitive stocks took the lead and interest rate sensitive stocks suffered losses. But the quarter ended with a series of softer than expected economic reports and another decision by the Fed to once again leave rates unchanged. Financials, especially, ended the quarter on a weak note, disappointed once again by the prospect of lower interest rates for longer. And only tech and energy stocks were positive in September, the latter group buoyed last week by the apparent agreement among OPEC members to trim production.

The Pace of Economic Growth in Q4 Remains Critical

The litany of economic data reports for August that disappointed was incessant. Manufacturing, industrial production, job creation, hourly wages, personal consumption, housing starts and home sales, and leading indicators were all weaker than expected, clear evidence of a mid-quarter soft patch. In the end, stocks staggered to the finish with just enough support to hold onto their gains from the start of the quarter, but with little momentum.

As the fourth quarter gets underway the pace of economic growth remains the central question. But there is reason to expect the news to improve. Inventory liquidation was a significant drag on growth in the first half, but is expected to diminish as a headwind as the cycle matures. Despite a mid-third quarter slowdown, consumer spending has been an ongoing support. In the recently revised second quarter GDP report, personal consumption grew at a pace of 4.3 percent, second only to the 4.6 percent pace of the fourth quarter of 2014 as the fastest quarterly growth rate of the post-recession recovery.

And one bright spot among the recent spate of disappointing data has been buoyant consumer confidence. The Conference Board’s report on consumer confidence for September hit a recovery high, and the University of Michigan’s report on consumer sentiment for September ended the quarter on an uptick from August. And non-residential fixed-investment rose for the first time in three quarters on a surge in intellectual property investment.

Of course, the pace of economic growth has direct implications for the long anticipated resumption of earnings growth, but that expectation has now been postponed until the fourth quarter. For the third quarter, earnings are expected to decline by 2.1 percent according to Factset, which would nevertheless be an improvement over the 3.5 percent decline of the second quarter, and revenues are expected to grow for the first time in almost two years. (The reporting season begins on October 11). Both are expected to grow in the fourth quarter, with earnings improving by 5.6 percent. If the pace of economic growth improves to a level of close to 3.0 percent over the second half as we expect, there is reason to believe that earnings growth will finally become a reality.

Additional Headwinds Likely

Beyond the question of economic growth, the fourth quarter will not be without its other challenges. In Europe, investors are waiting for the European Central Bank (ECB) to reveal its plans for policy in the New Year. The European banking system remains under a cloud of bad debts, capital adequacy questions and profitability concerns. And the political climate remains contentious, especially in the lead up to Italy’s constitutional referendum in December. The Bank of Japan has revealed its new strategy of manipulating the yield curve, but its ultimate effectiveness remains to be seen, and the strong yen remains a headwind to growth.

In the U.S., the Federal Reserve seems poised to raise interest rates in December if the data gives it enough cover. And, of course, there is the presidential election, which remains close in the polls with just five weeks to go. Given all of these uncertainties it is perhaps surprising that following a mid-September spike to the quarter’s highest reading above 18, the VIX index ended the quarter only slightly above 13, not terribly much above its mid-August low for the year of 11.3. Whether that relative equanimity persists also remains to be seen.

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The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a widely used measure of market risk. It shows the market's expectation of 30-day volatility. The VIX is constructed using the implied volatilities of a wide range of S&P 500 index options.

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