3 lessons from the Q3 stock market drama

What is clear is that the cycle of greed and fear has turned. Signs of change in market leadership are also clear. Regardless of the future, the stock market drama of the third quarter offers lasting lessons for investors.

Lesson 1: The market will fluctuate

According to investment lore, John Pierpont Morgan once responded to a forecast request with, “Young man, I think the market will fluctuate.” Whether Morgan or anyone else said it is actually beside the point. The quote speaks to both the futility of investment forecasts and the inherent volatility of stocks. It can also serve as a timely reminder.

Bull markets fuel complacency. The Morningstar US market index, a broad range of stocks, climbed 26% in 2023 and then gained another 14% in the first half of 2024. Ever since ChatGPT launched in late 2022, market excitement around artificial intelligence generated the dizzying stock price. earnings in companies such as Nvidia NVDA, Microsoft MSFT and Meta Platforms META. When markets set new highs, expectations become unrealistic. Investors forget that stocks can go down. The over 20% pullbacks of 2022 and 2020 seem to have faded from memory.

However, investor sentiment can turn on a dime. In the third quarter, AI excitement gave way to fears of a tight and expensive market amid macroeconomic and political risk. Volatility rose to levels not seen since 2022. Jobs reports, inflation print and earnings announcements caused selling. Both an unexpected interest rate hike by the Bank of Japan and an expected rate cut by the Fed contributed to the jitters.

Does it still matter if the market fluctuates? “Volatility is not risk,” savvy investors like to say. “Risk is the permanent depreciation of capital.” The problem with volatility is that it amplifies the cycle of fear and greed. Investors are more likely to buy volatile investments at a high and sell at a low—a phenomenon recently quantified by Morningstar’s Mind the Gap study.

Lesson 2: Diversification is not dead

“Links are back,” Morningstar Research’s Jason Kephart wrote in August. While stocks were down in the third quarter of 2024, the Morningstar US Core Bond Index climbed. The yield on the 10-year U.S. Treasury fell and bond prices rose, benefiting from a flight to safety and expectations of a rate cut. Multi-asset investors have seen diversification pay off. The Morningstar US Moderate Target Allocation Index, which is the traditional mix of 60% stocks and 40% bonds, preserved capital better than an all-stock portfolio in the third-quarter selloff.

Why is this noteworthy? After all, bonds are often referred to as “portfolio ballast,” mitigating losses during the equity bear markets of 2020, 2007-09 and 2000-02. However, fixed income has failed to play its traditional role of steadying the ship in 2022. Inflation and the monetary policy response are causing both stocks and bonds to fall in lockstep. Headlines proclaimed the “death of diversification” and “the end of the 60/40 portfolio.”

While the stock/bond relationship got back on track in the third quarter of 2024, investors learned in 2022 that correlations are dynamic. The relationship between stocks, bonds and other assets is constantly changing. There’s also a difference between high-quality, interest-rate-sensitive bonds, as represented by the Morningstar US Core Bond Index, and the riskier corners of fixed income. Both the Morningstar US High-Yield Bond Index and the Morningstar LSTA US Leveraged Loan Index have been more closely correlated with equities than with the underlying high-yield bonds over the past 10 years.

Lesson 3: Nothing is permanent except change

In a crisis, correlations can reach 1, as investors saw on August 5 when stocks plunged by investment style, size and geography. But in the long run, the market segments differ dramatically. For more than 10 years, growth stocks have outperformed value, large-caps have outperformed small-caps, and the US has been the place to be for equity investors.

“Rotation” was a term that evolved throughout the third quarter. Whether viewed through the lens of the Morningstar Style Box, sectors or investment factors, the leadership of the stock market has changed. The Morningstar Global Markets ex-US index outperformed its US counterpart in dollar terms. In the US, value stocks outperformed growth. The small highways have gathered. The Morningstar US Yield Factor Index outperformed in the third quarter, while factor indexes focused on quality and momentum, which led in the first half of the year, slipped to last place.

Will the rotation persist? Investors will be reminded that this is not the first time in the past decade that there have been signs of regime change. In 2016, the election of Donald Trump as president sparked a fierce rally in US small-cap stocks in sectors such as financials, basic materials, industrials and energy. They were perceived beneficiaries of a platform of tax cuts, regulatory rollbacks, turbocharged economic growth and protectionism. Tech stocks sank following the election of a candidate perceived to be hostile to Silicon Valley.

But the “Trump Bump” was ultimately a false head. By 2017, large-cap growth was again at the forefront as key agenda items such as infrastructure spending failed to move forward. Technology has been the best performing sector during the four years of Trump’s presidency.

Another apparent turning point came in 2022. The technology sector, which benefited so much from the pandemic, led the market down. Value stocks held up well, in part due to energy stocks benefiting from higher oil prices following Russia’s invasion of Ukraine. Then ChatGPT brought back growth stocks in general and the tech sector specifically in a big way.

In the long term, market leadership is highly volatile. After the dot-com bubble burst in 2000, value and lower capitals held back growth for years. Skepticism about the technology sector was pervasive. A commodity “super cycle” fueled by China’s booming economy led global financial markets in the early 2000s. US stocks experienced a “lost decade” while emerging markets and European stocks outperformed.

Consider that in 2009, US stocks made up 40% of the Morningstar Global Markets index (their weight is now well over 60%). The energy sector accounted for more than 10% of global equity market value 15 years ago, while it is now closer to 4%. Few predicted that U.S. stocks and the U.S. dollar would dominate so completely in the wake of a crisis in the U.S. housing market and financial system. How many expected the tech sector to reach such heights when the FANG acronym — for market darlings Meta Platforms (then Facebook), Amazon.com AMZN, Netflix NFLX and Alphabet GOOGL (then Google) — was first coined in 2013?

It does not predict. Prepare.

So what’s an investor to do? Figuring out short-term market direction is extremely difficult. It can also be bothersome for longer periods.

Diversification is always a rational approach in the face of uncertainty. Portfolios should be prepared for a number of scenarios. Because the future rarely resembles the past, the case for owning a broad set of assets is strong.