The financial markets enter the fourth quarter facing a combination of positive and negative forces. On the positive side, corporate earnings growth has been very strong this year, driven by a growing economy and continued enthusiasm surrounding the emergence of artificial intelligence. When companies grow their profits above expectations, their stock prices tend to appreciate. However, there are also some concerns that could harm corporate profits and stock prices going forward, including rising energy prices, inflation, interest rates, and stock valuations. So far this year, the positives have outweighed the negatives, as the S&P 500 Index ended the third quarter up 11.77% year-to-date, while the Dow Jones Industrial Average gained 5.91%. As for the bond market, the Bloomberg Intermediate U.S. Government/Credit Bond Index declined 1.49% year-to-date as of September 30, 2026.

Well before the war with Iran, inflation was a persistent problem for consumers and businesses. Rising oil and gas prices due to the war have led to even higher inflation for certain products. When inflation increases, interest rates in the bond market typically rise, as investors demand a higher yield to compensate for rising costs of goods and services. Rising bond yields can push stock prices down as investors may sell stocks to buy bonds, as bonds become relatively more attractive investments when higher yields are available.

In addition to bond yields rising due to inflationary pressures, interest rates in the bond market are rising because of credit concerns. The U.S. government continues to run large budget deficits each year, and total U.S. debt recently topped $40 trillion. Global investors are becoming worried about the credit quality of U.S. bonds and the fact that the interest payable on U.S. debt is becoming so large. This has created an environment in which bond investors who lend money to the U.S. government now demand higher interest rates to compensate them for added credit risk. Rising interest rates often slow economic growth because borrowing costs for corporations, consumers, and the government increase, thereby reducing demand for loans to buy goods and services. At this point, rising interest rates in the bond market have not yet harmed the economy enough to create a recession, but this is something to watch for going forward. That said, the market value of existing bonds has generally declined this year as new bonds have been issued at higher rates. 

While inflation and credit concerns are causing investors to demand higher interest rates in the bond market, the Federal Reserve Board, responsible for setting the overnight federal funds rate, has also shifted its focus from lowering short-term interest rates to raising them in order to constrain inflation. A new Fed chairman took office earlier this year, and he has proven to be more hawkish about raising the Fed’s target interest rate than many had expected. In fact, on Sept. 16, the Fed raised interest rates for the first time in over three years. While raising short-term interest rates may help reduce inflation, it could also harm economic growth, leading to lower corporate profits, upon which stock prices are based. 

Although corporations are generally beating their earnings expectations this year, the broad stock market is still overvalued by most traditional measures. After several positive years of appreciation, many stocks are not cheap, and the stock market typically corrects when rising prices get ahead of corporate earnings. That said, provided the global economy remains strong and corporate profits keep growing, any valuation-driven correction should be short-lived.

One oddity this year is that value-oriented stocks have generally outperformed growth-oriented stocks. Typically, when the economy is growing, growth stocks outperform value stocks because they can grow their earnings faster than value counterparts. Growth stocks also tend to be more aggressive than value stocks, and their higher risk profile typically leads to higher returns when the stock market is appreciating. One reason value stocks could be outperforming this year is that they are trading at lower valuations than their more richly valued, technology-centered growth counterparts. Also, when interest rates are rising, value stocks often outperform growth stocks because value stocks typically carry less debt. That said, we would not be surprised if value stocks lost some of their luster along with growth stocks during the next stock market decline. 

Finally, midterm elections are coming up soon, and investors typically dislike the uncertainty associated with elections. Therefore, the November elections could lead to some short-term stock market volatility. It will be important to see how changes in Congress might impact legislation related to the economy and the financial markets. However, midterm elections typically do not determine the long-term direction of financial markets, and it has historically been beneficial to invest for the long term regardless of which political party controls Congress. 

Although we are cautious about the short-term outlook, we remain optimistic over the long term. Based on current conditions, we still prefer the stocks of large companies with strong balance sheets over small companies, which generally carry more debt and are more vulnerable to the impact of rising interest rates. We also view foreign stocks in developed markets favorably, as they generally appear undervalued relative to domestic stocks. We continue to favor short-term bonds over long-term bonds because they provide a better risk/reward profile, especially if interest rates continue to rise. 

As always, we will continue to monitor ongoing economic and financial market conditions. In the meantime, please contact us if you have any questions regarding your portfolio or the financial markets in general.

* Index returns were obtained from the Wall St. Journal and Bloomberg on October 1, 2026.

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