It happened like clockwork. Earlier in the week, all three main U.S. averages re-tested their lows and then proceeded to bounce back, only to give it all back. That's what happens during corrections, but it is not over yet.  After all, it is October.

 

Readers will recall that last week I wrote that nine out of 10 times markets will re-test their recent lows. Naturally, this is more of an art than a science, so prices can bottom somewhat above or below those lows. In this case, the Dow hit its lowest level in four months. The S&P 500 Index slipped below its recent lows while NASDAQ got hit the worst, wracking up a total 10percent decline from its highs.

 

This is how it should be since all year long the markets have been led by the advances in the tech-heavy NASDAQ. And by the way, there was no new news on Tuesday. There was no event that anyone can point to for the decline. That also makes total sense when you understand that this entire pullback has been technically-driven. 

 

And it isn't over yet. We still have five days left in October and another six until the mid-term elections. The way the market has been acting this week, we could continue to see 1-2 percentage point-sized swings daily.

 

The fuel for these pyrotechnics is earnings results. Remember my warnings that earnings this quarter, although good, would not be "as good" as the past few quarterly results? As an example, Thursday evening, two of the big FANG stocks, Amazon and Google, reported after the close. Their top line revenue growth was less than expected, which came as a bit of a surprise to investors. No never mind that profits beat expectations since these days profits can be manipulated easily by simply buying back additional shares.

 

Index futures Thursday night dropped like a rock as a result, and Friday morning the Dow dropped 300 points on the opening. Earlier in the week, companies like Caterpillar and Boeing reported. Their announcements were enough to move the markets (up in the case of Boeing, and down on Caterpillar's results). Why, you might ask, do individual company results suddenly have the power to move markets like this?

 

It's all about expectations. Investors have been fretting about Trump's trade war all year. So far, the fallout has only impacted a few areas. Farming, for one, and maybe some companies in the steel business. The fear is that over time more and more companies will pull back investments, lose sales, or be damaged by these tariffs. And what may happen to one, may happen to all.

 

If you believed, as I do, that this is an inaccurate and rather simplistic view of the world than the fact that one company might see some fallout if tariffs are imposed does not warrant taking an entire sector, or in this case, an entire market down with it. However, markets are not rational at times. This is one of those times.

 

Friday, it was announced that the country's economy grew by 3.5 percent in the third quarter, which was faster than expected. Fearful investors barely paid attention to the news. That should come as no surprise. You can search to doomsday for a solid fundamental reason why we are experiencing this sell-off. You won't find one. Bottom line: the markets were overbought and in need of a healthy pullback. Don't over think this one and stay invested.

 

After this week's trade deal between the U.S., Mexico, and Canada, investors are waiting to see if China will now come to the table. What would it take for that to happen?

 

Mid-term elections could be the trigger. It wouldn't surprise me to see a deal before November — since the polls appear to favor the Democrats. Trump's tariff offensives, while supported by most of his base, are deeply disturbing to those who are feeling the brunt of foreign-trade retaliation.

 

Farmers, for example, and blue-collar workers in certain steel-related industries, are suffering. Many of them are also part of the 39 percent minority of Americans who support Donald Trump and his presidency. These predominantly white, uneducated voters might be swayed to vote against the GOP because of these tariff issues. That could mean a drubbing for the "Grand Ole Party" come November.  

 

A deal with China, even one that does little but save face, might be preferable to the president and his party than a big loss in the election booths. If one examines the successful deals the president and his men have negotiated thus far, we see some minor changes in the trade terms, but certainly not the massive overhaul in trade terms we have been promised practically every day for well over two years.

 

Minor fiddling around with auto manufacturing content and $40 million worth of reductions in Canadian barriers to milk imports (think American farm voters) is not a major overhaul of NAFTA. We have essentially cosmetic changes similar to those announced last week as part of the South Korea/U.S. trade agreement. 

 

It appears to me that we are simply witnessing a continuation of Trump's U.S. foreign policy of "Speak loudly but carry a tiny stick." Why should we not expect the same treatment in our on-going negotiations with China, as well as the European Community? A similar deal with China would have little to no impact on our terms of trade but would allow Trump to claim he has "solved our trade problems." It might also improve Republican chances in November.

 

As for the market's reaction, we celebrated with all the indexes soaring at the open on Monday. The S&P 500 Index, at one point, was just five points away from making a new all-time high. The Dow Jones Industrial Average did make a new high on Tuesday and another one on Wednesday. The other indexes were more subdued as investors sorted through the potential winners and losers of Trump's new U.S.-Mexico-Canada Agreement (USMCA).

 

Taking a 30,000-foot view of the markets, what I see are positive returns for six straight months. If we look back to 1928, there have only been 26 prior six-month periods with that kind of winning streak. In the month that followed these events, the S&P averaged a gain of 0.95 percent with positive returns 69 percent of the time.

 

Over the following three months, the index averaged a 3.92 percent gain with positive returns 85 percent of the time. There have been only five prior streaks where the index was up in each month from April through September. In those instances, the average gains were even better.

 

Next week, we begin the quarterly beauty pageant of earnings results for this year's third quarter. Depending on the results, we could see a continuation of the rally and a slow grind higher or, if earnings are disappointing, a sharp, short, pullback, so strap in and get ready.

 

Today marks the end of the third quarter for stocks in 2018. But it is the fourth quarter that will determine what kind of year it will be. Let's place our bets.

 

First, we should look at what could go wrong over the next three months. Tariffs probably lead the list. More of them, (although the dollar amount is minimal in the scheme of global trade), would be bad for sentiment within the global stock markets. Mid-term elections are a toss-up, but simply not knowing the outcome I count as a negative. Quarterly earnings results might also hold some risk for investors. And finally, the latest investor sentiment readings (a contrary indicator) are as high as they were back in January before the stock market sell-off.

 

Since there is no way of knowing what our esteemed president will do on the trade front, let's simply acknowledge that risk and move on. Mid-term elections are also an unknown quantity, but my bet is that the Democrats will take the House, while the GOP will maybe hold the Senate if they're lucky. In all likelihood, after a bit of volatility, the markets will move on regardless of results.

 

As for earnings, they may be a bit different than the pleasant, upside surprises we have become used to over the last two years. Negative pre-announcements by various companies are ticking up. As of this week, 74 out of 98 S&P 500 companies, according to FactSet, have guided lower for the third quarter. So, what gives on the earnings front?

 

It is simply confirmation of what Federal Reserve Chairman Jerome Powell told us this week about Trump's trade war: "We've been hearing a rising chorus of concerns from businesses all over the country about disruption of supply chains and materials cost increases."

 

Bottom line: you don't actually need tariffs to be implemented to impact economic growth. Trump's constant threats and tweets about what he might or might not do on the trade front is creating an atmosphere of uncertainty. Corporations are becoming more cautious, guiding down expectations, and generally delaying expenditures until they see what happens.

 

Right now, investors expect third-quarter revenue growth to average 7 percent, while year-over-year earnings growth should come in at around 20 percent. Sounds good, doesn't it? But those numbers are down from second quarter results of 10 percent revenue gains and 25 percent earnings growth. The fourth quarter expectations are even lower with 6 percent revenue growth expected and 17 percent gains on the earnings front.

 

In the past, I have discussed the phenomena of "peak earnings" and how the wonderful results of the past few quarters have been artificially inflated by one-off events. The Republican tax cut giveaways to the nation's corporations were squandered on buy-backs of shares, increases in dividends, and mergers and acquisitions, but those effects are winding down.

 

Despite the effort in Congress this week to make those tax cuts permanent (in hopes of propping up the markets until after the mid-term elections), it is doubtful the Senate will go along with it. Adding another $750 billion or so to the $1.2 trillion it has already cost to cut taxes this year seems to be a "bridge too far" even for a party that has abandoned all semblance of fiscal integrity.

 

The U.S. Advisory Sentiment data now places the bulls at 60.6 percent, the most bulls counted since Jan. 18, 2018, and the seventh straight count above 55 percent.  Usually, readings above 55 percent indicate caution. Over 60 percent signals elevated risk and the need to take defensive measures. 

 

On the surface, all these arguments should set us up for a bear market in the last quarter. However, every one of these arguments has been around for at least the last three months and look what the markets have done. The Dow is up 9 percent, the S&P 500 Index up 7.5 percent, and NASDAQ gained 7.7 percent. Bottom line: the markets have shrugged off the negatives and moved higher. Why should the fourth quarter be any different? 

 

Next week, Wall Street's big boys return to their offices. Campaigning for mid-term elections moves to the front burner, and tariff threats between the U.S. and China will likely escalate. Welcome to one of the worst months of the year for stocks.

 

It is true that both September and October tend to be negative months for the averages. Since 1945, the S&P 500 Index has, on average, lost 1 percent. In addition, it is a mid-term election year where Septembers are almost always rocky months for the market.

 

One could say that investors face an entire fall season of potential risks. Besides those I have already listed above, there will be the implementation of the new Iranian sanctions to contend with. And don't forget the recent free fall in so many emerging market currencies because of a stronger dollar and rising interest rates. We also have another budget deadline for Congress coming up. Last, but not least, are some events in Europe that bear watching.

 

The Italian budget, which is due at the end of September, could be contentious, since the budget promised to the voters may not be acceptable to the European Union. That could trigger another crisis of confidence like, but more serious, than, the recent troubles in Turkey. Brexit is another on-going concern, as is the outcome of our potential tariff talks with the European Union on autos.

 

All the above should maintain, or even elevate, that "wall of worry" that we have been living with since January. The good news: despite these concerns, the S&P 500 Index, along with most other averages, have reached record highs in the last week. The S&P is now up 9 percent for the year and NASDAQ is even higher.

 

Given these obstacles, readers should not be surprised that a growing chorus of market pundits are warning of a 5-7 percent decline in stocks "soon." OK, that's probably a fair guess, given the gains we've had, but so what. Do you really want to time the market here for a normal, and shallow pullback?

 

Statistically, while September and most of October are rocky months, the historical data says that whatever losses one incurs in the next two months, will be more than made up for by the end of the year. Are you good enough to guess the top, sell, and then get back in for a measly 5 percent? If you are, please manage my money.

 

Another thing with this "danger ahead" scenario is the number of people that are predicting this will happen at any moment. In the space of one week, my electrician, a dentist, two cab drivers and a librarian have all told me (and are convinced) that not only is the economy on its last legs, but the stock market was teetering on the edge of a precipice.

 

When I asked what led them to believe that this decline was imminent, they answered with conviction.

 

"They are all saying it."

 

I never did get them to explain exactly who "they" were. The answers ranged from "those guys on the TV," to "my book club members," or "a neighbor who is in the business." As a contrarian, I've heard these kinds of concerns in the past. It usually means that when the pack is leaning one way, you should be looking the other way. I say stay invested, look beyond a month or two, and prosper by the end of the year.

 

A reminder, there will be no columns over the next two weeks while my wife and I are in Norway on vacation.

 

As of Friday, we were in striking distance of a record high on the S&P 500 index. We have been here before, but something tells me that this time we just may break through. But for how long?

 

Granted, stock market volumes are exceptionally light, which is understandable, since we are heading in to one of the slowest weeks of the year. That makes any new highs suspect until volume improves. We would need to wait another week or so for that to occur. Next weekend is Labor Day and it is only after the holiday that the Big Boys get back into town.

 

What those players will do, once they are back in the cockpit, will determine the short-term direction of the market through September and into the end of October. There will not be a lot of upside catalysts to drive stocks higher during that period. But there are several issues that could pressure the downside.

 

Readers are already aware of the major risks: tariffs, higher interest rates, unpredictable tweets from the White House, etc. Some investors, as I mentioned last week, have already positioned themselves for an uptick in volatility by buying some of the more defensive sectors of the stock market.

 

We have also noticed that certain economic data points have failed to live up to the market's high expectations. That does not mean that growth has slowed. It just means that we may be reaching a bit too high right now for the numbers.

 

Even the Federal Reserve Bank's latest minutes reveal some concerns. Fed members are watching the developing tariff issue closely. Yet, they do not see any reason to stop hiking interest rates, but they are watching. Most central bank experts expect two more interest rate hikes this year (one next month and a second in December). Those expectations are already priced into the markets.

 

In an address to the annual Jackson Hole symposium of central bankers on Friday, Fed Chief Jerome Powell assured us that the economy is strong and that its performance will continue. Inflation is under control and he sees no signs of overheating.

 

Powell said that the Fed's gradual interest rate tightening policies will continue. He ignored the recent comments by the president, who has complained recently over the Fed's tightening policy, but Powell did say he was concerned by the government's burgeoning deficit,

 

the slow rate of wage gains, and the disappointing productivity among the nation's corporations. The Fed can do nothing about any of the above, however. Those are issues that Congress and the president must address.

 

Markets rightfully interpreted his comments as "dovish," at least on the margin. As such, readers should not expect a bear market anytime soon. At the worst, we could see more volatility over the next few weeks and months (both up and down). And while the earnings season is over for now (79 percent of companies "beat" profit estimates, while 72 percent beat revenues), analysts are already upping their forecast for profits and sales for next quarter.

 

As we head into the last days of the summer, I expect nothing negative to spoil your vacations. As for me, I want to advise readers that next week will be my last column until mid-September, when I return from a two-week vacation in Norway.