For the past two weeks I have been traveling in Europe. The continent is an economic mess. Yes, tourism is strong and, on the surface, all seems vibrant. But in most cases, governments are in tenuous states attacked from both the left and right. Regulations and an inability across the Eurozone to reach consensus on almost anything means that Europe moves forward at a snail’s pace trailing further behind the East (China) and West (U.S.) than ever before. But with all that said, European markets are outpacing U.S. markets in a year of surprising strength here. Why? In part, because the situation in key markets in Europe is a bit better than it was last year (think U.K. or Germany). But perhaps most important from a financial market standpoint, the dollar is down more than 10% versus the euro which totally explains the relative advantage of European stocks.
What becomes really apparent when looking globally is that what is happening in the United States is being replicated is some fashion worldwide. The old order is being rejected everywhere. While the solutions are different, the hope is that change will be for the better. Some countries, like the U.K. and Spain, move left. Others like Italy and France move right. While the U.S. skews Republican which seems to be to the right, the movement is populist at the MAGA core, right on some issues, left on others.
Against this backdrop, markets move higher. If one told me 6 months ago that a broad regimen of tariffs and a more isolationist policy would lead to a strong economy, I would have had my doubts. The full impact of tariffs hasn’t been felt yet but third quarter earnings so far still show corporate profit margins rising. While the tariff pressure may peak this current quarter and next, it appears that margin pressure from tariffs alone can be offset by slower hiring and other steps to offset their impact. No wonder stocks are at an all-time high!
We are at the crescendo week of earnings reports. Five of the Magnificent Seven report earnings this week. These five stocks alone account for about a quarter of the value of the S&P 500. Reaction to Apple#, Alphabet#, Amazon#, Meta Platforms#, and Microsoft# will obviously be impactful. Recent stock action suggests investor optimism.
I normally don’t comment on short-term issues, but today is the start of the last trading week of October. Those who track seasonal market movements, know that September and early October often are weak times. Part may relate to uncertainty in front of third quarter earnings reports, but a lot relates to mutual fund activity. Mutual funds almost all have October fiscal years. Why? Because they all must pay out to shareholders pro rate capital gains distributions before year end. An October fiscal year end allows them time to calculate, pay and report those distributions with enough time that shareholders can take their mutual fund gains and losses into account while doing their own tax harvesting. That is a long-winded explanation to say funds sell their losses to offset realized profits over the previous 11 months. Translation again, stocks that have been down all year, for whatever reason, come under selling pressure twice in the fourth quarter, once in October as mutual funds wind down their fiscal year, and again near year end as individuals do their own tax harvesting. Almost half of the Russell 3000 companies have lower stock prices now than on January 1. For the most of the balance of the year, the losses will remain under tax-selling pressure. For winners, it will be a mixed bag. For some, taxable investors may take some profits if they can find offsetting losses.
There is one other consideration, often explaining early October weakness. Companies cannot buy back their own shares based on non-public information, i.e. third quarter earnings results. Thus, companies on calendar fiscal years, cannot buy back shares from late September until a few days after earnings are reported. Given that stock buyback has been a major tailwind for years, that explains most early October weakness.
But not this year. As we know stocks closed last week at record highs. Whether Friday’s CPI report alleviated fears of rising inflation or acceptance that 3% is the new norm rather than 2% is academic for now. The Fed is going to lower the Fed Funds rate 25 basis points this week and will almost certainly do the same again in December, assuming the government shutdown is ended by then. In the short-term, investors like lower interest rates, especially when lower rates also pull the 10-year Treasury yield lower.
Markets almost always rise in the fourth quarter in years of strong gains over the first nine months. At the moment there is little reason to suggest otherwise this year. To be sure, there are risks. It’s economically OK for the government shutdown to go a bit longer but if it continues into traditional Christmas season after Thanksgiving, that would impact consumer spending meaningfully. Congress appears to be in semi-permanent recess, part of the food fight over the impasse. But being shut down means no other legislation passes and there are some issues that need resolution before year end. Already, government medical plan open enrollment is underway and subscribers don’t have all the relevant details. Tax forms for 2026 need to be prepared. If the shutdown is resolved tomorrow, getting what needs to be done by year end will be a challenge. And if it doesn’t, Washington will point fingers across aisles, but constituents will blame incumbents. So, there will almost certainly be an end reasonably soon.
Conclusion: for the next several months there are clearly more tailwinds than headwinds. Valuations are stretched but valuation excesses rarely trigger negative reactions by themselves. There needs to be a catalyst. What is that catalyst? Some may say excess speculation. That could be partially right. But the real catalyst is debt. During my trip I read Andrew Ross Sorkin’s new book “1929” describing in gripping detail what led to the Depression (labeled as such by President Hoover) and its aftermath. His previous book, “Too Big to Fail” detailed the Great Recession of 2007-2009. The cause for both was, in one word, debt. Debt feeds speculation. It accelerates risk taking. It accelerates risk taking not only in the stock market but everywhere. In 2005, literally half of all new homes sold were sold to non-occupants, second home buyers, flippers, and speculators. As more played the game, lenders, who make more money when they lend more, lowered lending standards. You know the rest. Similarly, speculation was rampant in the late 1920s. In 2007, the economy looked fine in the third quarter. By the fourth quarter the Great Recession had begun. By mid-1929 stocks were up more than 20% on top of terrific gains the year before. By late October, everything was crumbling.
So far, while debt levels are at or near record highs, ratios like margin debt to total equity market cap aren’t at record levels. Mortgages have not been as stretched as in 2007. But we are moving in the wrong direction and the Fed’s move to be more accommodative raises risks. I am not suggesting we are at August 1929 or October 2007. We aren’t. But I am suggesting we are far enough above the median in terms of credit risk to pay attention. We have recently seen a few financial company failures. Last year we saw a few bank failures. They can be explained away by sloppy management. Badly managed companies can be the only companies that die or the first to die.
Debt gives you leverage. You play with other people’s money. When it works, when used prudently, it’s a great way to accelerate growth or investment returns. But when it doesn’t, and when it doesn’t on a broad scale, watch out. Both in1929 and 2008, the tipping point came quickly with limited warning. But limited doesn’t mean none.
As an equity investor, I will tolerate 10-20% declines because I don’t want to pay 25% in capital gains taxes for a temporary (less than a year) correction. But 1929 and 2008 were different. I don’t see the threat of either now. I want to emphasize that. But there are enough yellow flags that say “Jim, be careful”.
So, that’s what I will do. Stay invested, buy something I feel is cheap or likely to grow faster than most think. But with an eagle eye on debt. If credit spreads start to widen meaningfully, that will be another yellow flag. If business failures increase, that will be another. Dodd-Frank moved a lot of credit risk away from the banks but it didn’t eliminate it. Hopefully, the yellow flags never again become red flags. But remember that debt has to be repaid; equity doesn’t.
Marla Maples turns 62 today. Monty Python’s John Cleese is 86.
James M. Meyer, CFA 610-260-2220