A Midterm Fourth Quarter

October 2026

The stock market faced a never-ending stream of challenges in the third quarter. These included WTI crude oil prices surging over 33%, the 30-year US Treasury yield hitting approximately 5.62%—its highest level since 2002—and the benchmark 10-year yield hovering near 5.23%, its highest mark since 2007, US gross national debt exceeding $40 trillion, the Federal Reserve raising the fed funds rate for the first time in over three years, currency interventions to support the Japanese yen, a steady weakening of the residential real estate market, the Middle East conflict expanding to neighboring countries and Yemen’s Houthi rebels bombing both the Saudi Arabian capital city of Riyadh and some key Saudi oil facilities. Given this string of troubling events, it is remarkable that for the third quarter the S&P 500 index and the Nasdaq Composite closed 2.0% and 2.5% higher, respectively. However, the broader market did not fare as well as seen in the third quarter decline of 2.7% in the Dow Jones Industrial Average and 7.5% decline in the Russell 2000 index.

Yet despite a challenging quarter, stocks ended with year-to-date gains of 15.6% in the Nasdaq Composite, 12.7% in the Russell 2000 index, 11.8% in the S&P 500 index, and 5.9% in the Dow Jones Industrial Average. We attribute this underlying stability in the equity market to robust earnings growth.

Seasonality and Politics

Seasonal patterns tend to be stronger than normal in the midterm election year. Most seasonal tendencies are tied to predictable ebbs and flows in liquidity driven by annual IRA funding, tax paying season, year-end tax-loss harvesting, quarterly mutual fund portfolio adjustments, and end-of-the-year hedge fund positioning. These liquidity patterns can be variable, but in midterm election years investor sentiment and market action around election day has been fairly consistent. History shows that stock prices tend to weaken in September and October prior to the midterm election, but rally soon after the election. This precedent has been dependable over time. Currently, geopolitical conflicts are hurting oil supplies, massive federal and hyperscaler bond offerings are impacting the debt markets, and inflation is troublesome globally. These factors are contributing to the poor sentiment in September and October.

Earnings Prospects Remain Solid

One might wonder why the stock market has not had a bigger decline given all the hurdles it faces, and we attribute this to good underlying earnings growth. At the end of the first half of the year, S&P 500 earnings were up 33% YOY versus the long-term average of 8% YOY. FactSet writes that analysts are looking for third quarter earnings to increase 29% YOY. If so, it would be the third consecutive quarter of earnings growth greater than 25%. As a result, while stock prices increased 15% in the 12 months ended in September, earnings grew 30% in the same period. Consequently, the trailing 12-month price-to-earnings ratio fell from 25.5 times to 22.5 times.

Price-to-earnings ratios have declined (representing better value) because investors are worried that 2026 could mark a peak in the earnings growth rate. Some AI-related stocks have also lost luster as analysts fear that the massive investment being made in data centers will not be supported by unconfirmed future cash flows. These are valid concerns. However, it is also important to note that investor pessimism is not a characteristic of a stock market bubble, neither is earnings growth of 33% YOY. In short, every bull market needs a reassessment and refreshing pause from time to time and that is what September and October provide.

the Economy is resilient

Despite the risks that inflation and rising interest rates pose to the markets, a major positive offset is the resilience of the consumer. In August, retail sales rose 6% YOY and when auto and gasoline station sales are excluded, core retail sales increased a healthy 5.6% YOY. Year-over-year gains in core retail sales have been averaging a robust 4.8% since early 2025. This is a nice turnaround from the weakness seen in 2022 to 2024. Retailers and bankers are noting that in the third quarter consumer strength is seen across a broad cross-section of households. This is all good news.

The manufacturing sector of the economy is also undergoing a renaissance. After being in contraction mode from November 2022 to December 2025, the ISM manufacturing index is steadily gaining ground. Job growth in the manufacturing sector also improved in recent months as reported by both the Bureau of Labor Statistics and the ISM manufacturing survey.

Durable goods shipments and new orders have also been strong. In particular, capital goods shipments excluding defense and aircraft (i.e., core shipments) increased over 11% YOY in August and new orders increased more than 14%. This rebirth of the manufacturing sector is a product of new fiscal and tariff policies as well as AI demand for data centers and utilities. Therefore, it is no surprise that the Bureau of Economic Analysis recently revised first quarter GDP to 2.5% and increased second quarter GDP by 0.7% to 2.2%. It was also good news to find that the Federal Reserve’s favorite measure of inflation – the PCE deflator excluding food and energy – was unchanged in August at 3% YOY.

In sum, there has not been a pause or correction of 10% or more in the equity market since early 2025. One is overdue, and if it materializes we would use it to readjust portfolios. Earnings growth may decelerate in 2027, but given the productivity gains we see materializing from the implementation of AI and the underlying strength of the economy, earnings and the bull market should remain intact well into 2027.

*Stock, index, and sector prices are as of September 30, 2026

Gail Dudack

Chief Strategist

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