Confusing signs will make for a lively fourth quarter

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As the third quarter winds down, the final stretch of the year looks set to start with some big questions that need answers. At the top of the list: Have stocks already peaked?

Financial markets are by no means teetering on the edge of disaster, but September delivered enough drama to rattle many investors.

In the United States, the S&P 500 had a weekly drop in two of the past three full weeks of the month. Canada's S&P/TSX composite index fell as much as 5 per cent during September, putting it on track for its worst one-month performance in more than two years.

Of course, it is perfectly normal for stocks to encounter some turbulence; strategists would even say it is healthy, because market setbacks can prevent valuations from sky-rocketing.

But several issues are simmering beneath the surface of these broad market moves, and they are going to have to be resolved before the bull market resumes.

For example, small-capitalization stocks have been leading the way down. The Russell 2000 fell as much as 5.9 per cent in September – a steep drop that looks even worse when you consider that the small-cap index peaked way back in March.

If you don't invest in small-cap U.S. stocks, you might not be concerned about the downturn. But perhaps you should be: The declines resonate with all investors because smaller stocks are often perceived as leading indicators.

That is, their declines could reflect the start of a long-overdue market correction – a downturn of 10 per cent or more that hasn't occurred in about three years.

But there is another way for this issue to be resolved, without taking the market down.

Ed Yardeni, president and chief investment strategist at Yardeni Research, argues that investors are simply rotating out of pricey small stocks and into cheaper large ones.

He noted that the S&P 600 – another small-cap index – saw its price-to-earnings ratio rise above 19 in March, based on estimated earnings, up from 15.2 at the start of 2013. It has since retreated below 17 with the recent downturn. That's a lot more expensive than the large-cap S&P 500, whose estimated price-to-earnings ratio has been hovering around 15.

"Our view has been that many Small Caps significantly outperformed Large Caps last year, and were vulnerable to underperforming this year," Mr. Yardeni said in a note.

The market is also struggling with the implications of weaker high-yield bonds. The SPDR Barclays High Yield Bond exchange-traded fund has stumbled 4.5 per cent since June and is now approaching its lowest level in nearly a year.

That ends a strong run as investors embraced an improving U.S. economy, low default rates and interest rates that are stuck near zero per cent.

Again, high-yield bonds can be seen as harbingers of broader market issues if the declines reflect an impulse among investors to cut back on risk and take a more cautious stance ahead of higher interest rates, starting as early as next year.

But nothing is simple here: The declines could be nothing more than an adjustment amid stretched valuations – and the fourth quarter should shed some light on which view is right.

Government bonds aren't making the outlook any clearer. The yield on the 10-year U.S. Treasury bond has retreated below 2.5 per cent again, even as the U.S. economy grew a remarkable 4.6 per cent in the second quarter, at an annualized pace.

"It may be true that the stock market is getting ahead of itself by discounting double-digit earnings growth for next year but the [government] bond market is priced for either another recession or some facsimile thereof," said David Rosenberg, chief economist and strategist at Gluskin Sheff & Associates, in a note.

Add it up, and financial markets are pointing every which way as we head into the fourth quarter. The apparent confusion will make for a lively three months.