Markets have been walking a fine line, with a still-struggling economy on one side and hopes for a COVID-19 vaccine breakthrough on the other. Heading into the fourth quarter, there are both encouraging signs and cause for caution.

The stock market rally is top heavy

The largest five stocks by market cap in the S&P 500® index—Apple, Microsoft, Amazon, Facebook and Alphabet/Google—have dominated the rally in recent months. This concentration was considered a risk, because a pullback in even one of those stocks could lead to a broader market decline.

The risk was borne out in early September, when investors rotated out of technology and other high-flying stocks into other areas of the market—including defensive stalwarts like utility stocks—and the broader S&P 500, as well as the Nasdaq Composite, dropped sharply. Despite the recent volatility, the top five stocks still make up about a quarter of the S&P 500’s market capitalization (and 38% of the Nasdaq’s), and the risk remains.

There are positives and negatives for markets and the U.S. economy, according to Schwab Chief Investment Strategist Liz Ann Sonders. These include:

  • Small traders continue to dominate the options market, and last week’s market volatility did not discourage them—in fact, they added to their bullish bets. This is typically considered a contrary indicator; although speculation has been rampant for much of the summer.
  • Employers have rehired workers, job cut announcements have dropped and job openings are up; but the number of permanent job losses has grown.
  • Productivity has increased, aided by the COVID-19-related shift to working from home—a future positive for corporate profit margins. Productivity is one of the two main drivers of gross domestic product (GDP)—the other being labor force growth, which has also been rising.
  • GDP, down a stunning 31% in the second quarter (quarter-over-quarter at an annualized rate), is expected to gain nearly 30% in the third quarter, according to the Atlanta Federal Reserve Bank’s GDPNow forecast.

“We are arguably in the midst of the ‘gale of creative destruction’ in the drivers of the U.S. economy and its labor force,” Liz Ann says. “It can (and will) create space for creative new companies and technologies to emerge, but not without some destruction along the way—hopefully with much of it now behind us.”