By: Darren W. King | Wealth Management
Equity markets in the third quarter remained relatively stable with a modest 2.3% S&P 500 quarterly return. The bulk of the third quarter return was energy shares which were up 17%, as the Iran conflict has dragged on. The S&P 500 concluded September returning 12.73% this year. The technology-heavy NASDAQ ended the third quarter up 16.09%, while the DOW Jones Industrial average ended the third quarter up 7.18%. The Russell 2000 Small Cap Index finished the quarter gaining13.87% for the year but sold off 7% in the quarter. International developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE), closed the third quarter up 10.91%. The MSCI Emerging Markets Share Price Index closed September up 23.52% and has been the best returning asset class thus far in 2026. Money flow into small-cap, and international markets coincided with investor diversification into lower valuation investments in 2026. The story for the third quarter was rising interest rates and rising energy prices capping equity gains in August and September.
The first three quarters of 2026 witnessed the AI “pick and shovel” trade gain momentum as beneficiaries of the AI buildout led the market higher. Semiconductor stocks and energy companies posted strong returns. S&P 500 sector results through September: Energy 40.28%, Technology 28.38%, S&P 500 12.73%, Health Care 10.15%, Materials 8.82%, Industrials 8.54%, Consumer Staples 5.98%, Real Estate 5.30%, Communication Services 4.47%, Financials -1.43%, Utilities-5.65%, and Consumer Discretionary -5.82%. For 2026, a very concentrated AI capex beneficiary trade was the story with the Philadelphia semiconductor Index up 79% in 2026 and energy stocks were the best performing economic sector up 40% for the year. Only energy and technology sectors outperformed the S&P 500 return in the first three quarters of 2026. Utility, consumer stocks, and financial stocks lagged with higher inflation and higher interest rates hurting these sectors.
Earnings growth exceeding prior expectations has been the story in 2026 with year-over-year earnings up 93% for the energy sector and up 53% for technology shares alone. For 2026, the S&P 500 is expecting 32% eps growth which is up from 24% at the end of the second quarter. The forward 12-month P/E ratio for the S&P 500 is 19X, lower than the five-year average P/E of about 19.8X and right at the 10-year average P/E of 19.1X. Currently, the market is estimating 32% earnings growth on 12% revenue growth in 2026, and an additional 16% eps growth is expected in 2027. Profitability remains high for S&P constituents, with net profit margins currently at 15%, compared to 5-year average profit margins at 12.6%. Average equity strategists’ bottom-up price targets for the S&P 500 in 2026 are 9280, currently 19%higher than current trading levels. In short, the backdrop for equities in 2026 remains supportive for continued modest gains with markets recognizing the above trend earnings growth while also factoring in higher interest rates and higher inflation. Current valuations have reacted to higher interest rates and inflation moving in the wrong direction, which is a positive setup once interest rates stabilize.
In a highly anticipated move, the Federal Reserve raised rates 25bps to a range of 3.75-4.00% at their September meeting. After holding rates steady for 5 meetings, the latest interest rate hike marks the first interest rate increase since 2023. In their statement, the Federal Reserve acknowledged still elevated levels of inflation and updated Fed outlook to include the possibility for an additional rate hike by the end of 2026 and possibly further rate hikes in 2027. The Fed now forecasts full year 2026 GDP growth to be 2.4%, revised up from 2.3% in June. The median year-end unemployment forecast for 2026 was moved lower by .2% to 4.1%. Core PCE inflation, the Fed’s preferred inflation gauge, was revised higher to 3.4% in 2026 (previously 2.7% in January). Economic growth is accelerating and a swift reversal in rising inflation numbers is proving to be highly unlikely without further Fed intervention or positive developments in Iran.
The 10-year treasury yield rose by 112 basis points through September of 2026, starting the year at 4.17% and ending the third quarter at 5.29%, while the30-year treasury ended the third quarter up 79 basis points to end the quarter at 5.63%. Longest duration bonds underperformed shorter duration issues as yields increased across all maturities in the first three quarters of the year, affecting long-duration bonds more. Long treasuries were down 7.62% in 2026, while intermediate treasuries were down 1.46%. In a risk-off trade, higher credit quality outperformed the lowest credit quality issues. Aaa rated bonds within the Barclays U.S. Aggregate Index were down 1.46% in the first three quarters of 2026, while Baa rated bonds were down 2.71% during the same period.
The Bloomberg Dollar Spot Index finished September with the dollar having strengthened 1.3% compared to our trading partners as investors rushed to the safety of the dollar as American economic growth has strengthened over the past several months. However, the dollar has still weakened 7.6% from the beginning of 2025 as international capital market flows have incrementally diversified away from an US severe overweight position. Light crude oil futures are up 57% over the first three quarters of the year. West Texas crude closed September at around $90/ barrel from $57 at the beginning of the year. 30-year mortgage rates rose from 6.25% at the end of 2025 to 7.23% by the end of the third quarter, while 30-year treasury yields rose 79 basis points to 5.63% from 4.84% at the end of 2025.
According to the Bureau of Labor Statistics, the September jobs report showed 29,000 jobs added during the month, much lower than forecasted monthly jobs growth expected to be around 81,000. Over the past 3 months, the economy has grown by an average of 51,000 new jobs/month compared to monthly jobs growth over the past 5 years greater than 200,000/month. The September jobs number reported unemployment at 4.2%, which has remained in a tight band of 4.1% to 4.3% since March of this year. The labor force participation rate rose in September to 61.8% from 61.6%, the highest level since May as workers entered the workforce. For September, average hourly earnings rose 3.0% over the past year, the lowest level since May 2021, while recent inflation numbers were reported at 3.4%. In short, the weak June jobs number is expected to push the next Fed rate hike out to December as the Fed will most likely see inflation numbers higher than annual wage growth as worrisome for consumer spending and the economy.
Annualized retail sales, through August of 2026, were up 6.0% over the past year, compared to the consumer price index’s measure of inflation up 3.4%. Excluding gasoline station sales, which were up 21% over the past year, retail sales were still up a healthy 5.6%, dispelling any signs that the consumer is struggling. In fact, total retail spending across a broad range of categories, such as restaurant spending, sporting goods, and online and department store sales were up in a 5%-10% range. Spending on necessities, such as healthcare, grocery stores, and restaurants were up much more modestly in the .5% to 2.1% range. With consumer spending two-thirds of our economy, retail sales in the first three quarters of 2026 surpassed all expectations. In short, the consumer remains resilient, but current retail spending clearly shows inflation once again entering the picture.
As inflation and interest rates moved higher in the third quarter; equity investors have stuck with a narrow set of AI CAPEX trades that continue to work for now. International, value, interest rate sensitive, and small cap shares have underperformed as rates have risen over the past quarter. We see the risk reward for equities outside the AI trade improving through year-end. This is especially true as market valuations have re-rated to more attractive levels over the course of 2026. Investors have not become complacent and are questioning whether the currently stellar profit growth can continue. We are not looking to chase the Tech/AI trade and still see other areas of the equity market gaining favor as interest rates stabilize. We continue to favor cyclical sectors over defensive stocks and advise the continued diversification into a larger international, small cap, and value allocation. We continue to focus on equities that see increased efficiency from AI technological advances, continued deregulation within financials, and value in the health care sector. We are deemphasizing consumer sectors with the expected continued pullback in discretionary spending levels. With earnings growth rates in 2026 somewhere in the 35% range; we do not see a bear market in stocks in the near-term, despite higher interest rates.
Within fixed income markets, a bond selloff started in February when 10-year treasuries proceeded to move from 3.94% to the current 5.24% yield, a 24-year high. In short, term premiums, or extra payout investors demand in yield to hold long-dated assets commenced. A sustained term-premium increase would add to the pressure on the market from elevated inflation and geopolitical shocks, robust economic growth, plus a flood of borrowing both from deficit-running governments and companies investing inartificial intelligence. Our outlook is for interest rates to move lower following the Iran energy inflationary scare, whenever it happens, and to take advantage of historically high interest rate levels now. With bond maturities and reinvestment, we are extending duration and buying longer-dated maturities and trying to take advantage of this run up in yields while it holds. If the economy falters with a cost weary consumer; the Fed has ample room to move rates lower from current semi-restrictive Fed fund levels at 3.75% to 4.00%. Bond allocations would provide a hedge to any equity market weakness should a slowing economy unfold.
Click here to read the Q3 2026 Market Summary.
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Data Sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Dept. of Commerce (GDP, retail sales, housing); Institute for Supply Management (manufacturing/services). Factset (S&P 500 statistics); Performance: based on data reported in Bloomberg (indexes, oil spot prices, foreign exchange); News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources, such as government agencies, corporate press releases, or trade organizations. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied upon as financial advice. Forecasts are based on current conditions, subject to change, and may not come to pass. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
