Market outlook for the 4th quarter and beyond

Why the U.S. stock market remains in a long-term secular positive trend

Recent stock market volatility brings into question the health of the most recent five-year-plus growth trend line of the U.S. equity markets.

So what do the latest dips in the stock market indicate for the current October-December quarter and into 2015?

Job growth for September came in stronger than expected, with unemployment dropping below 6 percent. Of concern, the labor-force participation continues to fall, dropping to 62.7 percent in September. In addition, wage growth continues to stall and industrial production and factory use are showing signs of stagnation.

Paralleling such trends, Europe and China have seen slowing economic growth. In addition, geopolitical turmoil provides an uncertain international backdrop. As a result, many stock market watchers claim the world economy is now slowing, with the U.S. stock market overvalued and overdue for a correction. I believe the market is not overvalued at this time.

I also believe the U.S. stock market remains in a long-term secular positive trend. It may well tradeoff in the near term, and bearish sentiment has been increasing of late. In the short term, the market has traded sideways and downward, but after the November election it will finish the year strong. Why? The bottom line is the market likes certainty, and once this election cycle is over, we will have political certainty – at least for a while.

Also, keep in mind economic indicators seldom go up in straight lines.

Corporate earnings continue to grow, and inflation remains subdued. The U.S. economy grew more than 4 percent during the second quarter after being in negative territory the first three months of the year. In addition, second-half GDP is trending toward a 3 percent rate, and a strengthening U.S. dollar means lower commodity prices, such as oil, and improved consumer confidence.

Of note, of the 21 companies reporting earnings through Oct. 5 for the third quarter of 2014, 16 showed earnings above average estimates and 14 have reported sales above average estimates. That is a positive sign. Company earnings drive stock prices and while the rate of earnings growth may slow near-term, in part because of a strengthening dollar, the direction is still positive.

Bond bull market

Stock buybacks remain strong because companies have strong cash flows as well as historically high profit margins, leading to diminished stock supply. A decreasing supply of stock shares relative to an increasing amount of individual and company funds available to invest – all within an improving economy – means the market's run is not yet complete.

The big surprise of the year is the continuation of a bond bull market, with rates actually decreasing even as the Fed continues "tapering" its bond-buying program.

Bonds are generally overvalued, and it's been a waiting game for when U.S. rates begin the inevitable climb to normalcy. While rates could very well slip lower during the next several weeks because of global political and economic turmoil, a strengthening U.S. dollar and a decline in the forward price of gold are both harbingers of a turn in domestic rates.

Another positive sign for the forth quarter is the relative underperformance of U.S. mutual funds so far this year. Historically, when fund managers underperform going into the fourth quarter, the market has gone up at twice the rate compared to those years when managers outperform their relative benchmarks. The reason: asset management compensation is also performance-based.

One area to consider investigating would be large cap names, particularly in health care, technology and consumer stocks. How will a recently strengthening U.S dollar translate into non-U.S. asset stock prices?

In the near term, with a relative stronger U.S. currency and economy, individual stock investors would be wise to stay closer to home.

Also near term, the bond market is tough to gauge. A less than average allocation to the fixed income market is likely warranted at this time. So-called "alternative bond funds" are all the rage right now. But buyers beware – a small allocation may be warranted, but how such funds perform in a challenging market environment is uncertain. These funds typically contain speculative bets on interest rate movements.

In our 2014 Market Outlook published last winter, New Castle Investment Advisors said the S&P 500 should finish up by some 9 to 13 percent this year. Looking only at the S&P 500 as one measure of the U.S, stock market, it will likely reach that level by year-end – and even exceed it – because of prevailing economic dynamics. This positive trend should continue into early next year.

One caveat to this forecast concerns prevailing international headwinds. Any unexpected consequential event or events could rapidly impact a positive market outlook. Bottom line: be diversified, check your emotions and invest in good, solid companies.

Mark Connolly is principal of New Castle Investment Advisors LLC, an asset management firm specializing in customized portfolio management.