3Q The Catch Up Quarter

Not long ago, we frequently heard comments like “this rally is unsustainable,” “only the Magnificent 7 stocks are rising,” and “technology is the sole driver of the market.” It took just three months for that narrative to shift, as the technology sector has stagnated since June 30. In strong markets, one sector typically leads the way, and over the past decade, that role has been filled by technology. While some may be frustrated by the dominance of tech, it’s entirely natural given that technology permeates almost every aspect of our daily lives. The largest, most innovative, and most profitable companies are rooted in this sector.

In rising markets, investors often express concerns over lagging stocks or sectors until the inevitable occurs: the catch-up. This is a fundamental aspect of market dynamics—the lifeblood of bull markets. The market trends higher as leadership rotates between sectors, allowing some to rest while others take the lead. Sometimes, a particular sector may lead for an extended period or become slightly overextended, appearing less healthy, but this rotation is a typical feature of market behavior.

It's true that at the end of the second quarter, market breadth looked concerning. A very small percentage of stocks was driving index returns, with only about 20% of stocks in the index outperforming the broader market. At one point, only 100 of the 500 companies in the index were delivering returns greater than the index itself.

However, everything changed suddenly at the start of the third quarter, as stocks across various sectors began to catch up. Interestingly, it wasn’t the technology sector that led the charge—in fact, the Technology sector as a whole remained flat throughout Q3. Instead, the other sectors experienced some of their best performances of the year.

The following chart illustrates the performance of the S&P 500 index sectors at the end of Q2 compared to their performance at the end of Q3.

This chart highlights how every sector had a strong third quarter, with only two exceptions: Energy and Technology, which were clear laggards. The catch-up across sectors was impressive, yet the heavy concentration of the S&P 500 in Technology is evident here. Despite significant strength across most sectors, this was not fully reflected in the index's performance. While the index advanced by 6.8%, nearly all sectors posted returns above 10%.

Utilities, Real Estate, Industrials—really? These aren’t the sectors you typically see in headlines or hear people discussing, yet their performance has been remarkable. One factor driving this strength could be the decline in yields. These three sectors are highly sensitive to the cost of capital, and lower yields are generally favorable for them. The Federal Reserve’s 50 bps rate cut, along with the decline in the entire yield curve, likely contributed to the boost in these sectors.

In the following chart, we can observe the yield curve at the end of the second quarter compared to where it stands today. The most significant changes have occurred in the short end of the curve, with a potential steepening already starting from the 2-year maturity.

Looking deeper from a top-down perspective, if all sectors performed well in the third quarter, the stocks within those sectors followed suit. The percentage of stocks outperforming the index in Q3 was remarkable, with over 60% of stocks beating the S&P 500. That translates to more than 340 stocks outperforming the index, a significant improvement from the year-to-date figure of just 100 stocks at the end of the second quarter. Most importantly, this outperformance came with participation across almost every sector.

One key theme that we cannot overlook is the strength in Utilities. As part of our top-down analysis, below are the top 10 performing stocks in the S&P 500 as of the end of the third quarter.

It's surprising that among the top 10 stocks in the S&P 500, four are from the Utilities sector. This could potentially be tied to a key theme related to AI. There’s growing debate about energy consumption, with three major trends poised to significantly boost demand: data centers and AI, electric vehicles, and cryptocurrency. The energy consumption from these industries is expected to rise sharply, and without increased capacity, we may face energy shortages in the future. One solution to meeting this zero-carbon energy demand is nuclear power, a topic that remains highly controversial, but many analysts agree on its potential.

Vistra Corp (VST), the top performer of the year, is an energy generation company and the fourth-largest nuclear energy producer in the U.S. Its recent acquisition of Energy Harbor has positioned the company as the second-largest nuclear energy producer in the country. This may be a key driver behind the strength in utility companies focused on nuclear energy, as these firms are less constrained by the heavy regulation that limits growth opportunities for other types of utilities.

This impressive performance in Q3 could be just the beginning. Currently, the percentage of stocks outperforming the index year-to-date stands at around 35%, a significant improvement from the 20% we saw in June, but still below the historical average. In the next chart, we can observe the percentage of stocks outperforming the S&P 500 since 1980. If this current strength proves sustainable, there could be considerable upside potential in Q4.

You might be wondering—only the start? After all, the S&P 500 just posted its best 9-month performance to start a year this century. However, the fact that yields have remained elevated for such an extended period means there is still significant cash sitting on the sidelines. If yields continue to decline, as some expect, this sidelined cash may start seeking alternatives to money market funds. This shift could add further fuel to the equities rally.

It’s true that the market appears somewhat complacent, especially given the recent geopolitical tensions in the Middle East, elevated valuations, and the upcoming U.S. elections. Volatility has been slowly rising, and in the coming months, several factors could trigger further spikes. With the market in a complacent state, and as we enter in one of the historically weakest months for stocks, any negative news could easily lead to selling pressure, which might even be a healthy correction given the current conditions.

All eyes are now on the earnings season. Below are the median analyst estimates for Q3 sales and earnings growth for each sector in the S&P 500.

It will be interesting to see if companies can meet these expectations, and this is where attention should be focused right now.