September lived up to its reputation as being the worst month for the stock market. Stocks tumbled for a second straight month, accelerating a downturn that is chipping away at fund investors' 2023 gains. Investors can only hope October turns around the selling.
The average U.S. diversified stock fund tumbled 4.9% in the final month of the third quarter. That trimmed its year-to-date return to 8%, says Refinitiv Lipper data.
Three words sum up the main trigger of the market downturn: surging interest rates.
The Federal Reserve kept its key interest rate unchanged in a range of 5.25 to 5.50% at its September meeting. But it raised projections for rates in 2024 and 2025. And that hurt investor sentiment because it drove home the sobering message that borrowing costs will remain higher for longer as the Fed tries to tame inflation and cool a still-robust economy.
"The reality started setting in that the Fed might need to keep rates elevated way longer than the market thought," said Mannik Dhillon, president of Victory Solutions, a platform of asset management firm Victory Capital. And that shift also raised fresh fears about the health of the economy as higher borrowing costs start to bite consumers and businesses. "You start to worry that the 'soft landing' everybody was expecting, maybe it won't be so soft," he said.
Stock Market Investors Fear The Fed
The Fed's hawkish message also increased fears that the Fed isn't done hiking rates and will increase rates one more time this year. And that caused selling in the bond market, which pushed the yield on the 10-year Treasury note up roughly a half a percentage point in September to nearly 4.6%. Bond yields move in the opposite direction of prices. Early in October, the benchmark bond climbed above 4.8%, its highest level since 2007.
Falling bond prices was a big reason why Direxion Daily 20+ Year Treasury Bear 3X Shares, a fund that bets against bonds and profits when bond prices fall, was the best-performing domestic long-term fixed income fund with a gain of 28.78%.
Investors will be closely watching what the Fed says and does with rates. They'll also be eyeing the upcoming third-quarter earnings reporting season to glean clues as to how big a headwind higher rates have been for the nation's businesses.
Declines All Around
In September, all four major U.S. stock indexes finished lower. The small-cap Russell 2000 was the biggest loser for the second straight month, tumbling 6.03%. The tech-heavy Nasdaq fell 5.81%, the S&P 500 declined 4.87%, and the Dow Jones Industrial Average gave back 3.5%.
Red ink drenched both mutual fund and ETF monthly score cards, too. Virtually all types of fund suffered. The average large-cap, midcap, and small-company fund all fell, with losses ranging from 6.07% for small-cap growth funds to a 3.47% slide for large-cap value funds. Among sector equity funds, only natural resources funds, which gained 0.88%, and energy MLP funds, which edged 0.25% higher, finished in the green.
Investors who own S&P 500 index funds saw their account balance shrink 4.82%, on average. The major benchmark was hurt by monthly declines suffered by megacap tech stocks that have been driving the market higher this year. Aside from a gain eked out by Facebook parent Meta Platforms, the other members of the so-called Magnificent Seven — Apple, Microsoft, Tesla, Alphabet, Amazon.com, and Nvidia, the leading AI chip provider — all finished the month lower.
For a second straight month, all the top-20 diversified stock ETFs as well as the 10 largest ETFs, ranked by market cap, posted losses.
Growth Stocks Struggle
Many of the biggest fund and ETF losers were those that invest in growth stocks, innovation companies or less-established smaller companies.
For example, the biggest loser in the large-cap core fund category was Roundhill Meme, which tracks so-called meme stocks, such as electric carmaker Rivian and movie theater chain AMC Entertainment Holdings, popular with individual investors.
The worst performer in the multicap core space was VegTech Plant-based Innovation & Climate ETF which invests in plant-based foods. Similarly, Jacob Small Cap Growth (JSCGX) was the worst-performing small-cap growth fund thanks to a 12.2% drop.
What's Next For The Stock Market?
So, what's next for the stock market and what types of stocks will do best?
If rates remain elevated, that means the cost of capital will be higher. In that type of environment, quality companies that generate a lot of free cash and have less-indebted balance sheets are what investors should be looking for, says Dhillon. And for those who think the economy will contract, focusing on defensive companies, such as companies that sell consumer staples or health care stocks, that can weather a slowdown is key.
Allen Bond, a co-manager of Jensen Quality Growth (JENSX), a 2023 Best Mutual Funds winner, is also taking a more defensive approach now, given the continued headwinds from higher inflation and rates, as well as concerns over an inverted yield curve. "We are cautious," said Bond, who is also head of research at Jensen Investment Management.
If inflation persists, stocks with pricing power that have competitive advantages in their industries will be winners. "You want to own companies that are going to be able to control their own destiny," Bond said. He still likes a few of the megacap secular growers that have been market leaders. Of the so-called Magnificent Seven, he likes Apple, Alphabet and Microsoft.
Tapping AI Excitement
To take advantage of the artificial intelligence (AI) trend, he likes Amphenol. The company makes electronic connectors that are key components in many businesses, such as electric cars, data centers, smartphones, and other industrial applications. "Their connectors are increasingly a critical part of everything," said Bond.
Bond is also now a fan of more defensive health care names, such as drugmakers with global scale and strong product pipelines like Pfizer and health insurer UnitedHealth Group.
Where the market is headed next comes down to two traditional drivers: rates and earnings, says Jurrien Timmer, director of global macro at Fidelity Investments. But for profits to reaccelerate, the Fed will have to ease up, he says.
"For the stock market to start playing the (bullish) playbook of earnings recovery, the Fed has to at least stop raising rates and maybe even lower rates," said Timmer. "But the big question is how long is the Fed going to stay up (with rates)? And that question can only be answered by the inflation data."
Looking For Values
Investors with a value streak, Timmer says, should start looking at small-cap stocks, which have been hurt the most by higher rates.
"If the Fed takes its foot off the brakes at some point, investors must ask themselves: Do I pay a hefty premium for one of these big (megacap) growers, or (do) I pay a much more attractive valuation for one of these smaller companies or a basket of smaller stocks? I think the valuation is there, but we just need to wait for the catalysts (that will) broaden the market."
