Citi's Scott Chronert: Look for volatility into Q3, but be prepared to trade year end rally

Key Concepts

S&P 500 Year-End Target: Citi's forecast for the S&P 500 index at the close of the year.
Southside Consensus: The average forecast from sell-side analysts (investment banks).
Upside Surprise & Estimate Increases: When actual earnings exceed analyst expectations, and analysts subsequently raise future earnings forecasts.
Beat and Raise Narrative: A company reporting better-than-expected earnings and simultaneously increasing its future guidance, often seen as a strong positive signal.
Market Weight: An investment recommendation to hold a sector or stock in proportion to its representation in a benchmark index.
Overweight: An investment recommendation to hold a higher proportion of a sector or stock than its representation in a benchmark index.
Tactical Perspective: A short-term investment strategy, often reacting to immediate market conditions or sentiment.
AI-Affected Market Cap: The portion of the S&P 500's total market capitalization that is significantly influenced by Artificial Intelligence trends and expectations.
XRT: The ticker symbol for the SPDR S&P Retail ETF, often used as a proxy for the consumer discretionary sector.
Cyclical Part of the Market: Sectors whose performance is closely tied to the overall economic cycle, such as financials and certain retailers.
Rate Trajectory: The expected path of interest rates, particularly the anticipation of future rate cuts by the Federal Reserve.
Alts (Alternative Investments): Non-traditional asset classes like gold and cryptocurrencies, often considered for diversification or hedging.
Momentum-Driven Equity Market: A market where price movements are largely sustained by the continuation of existing trends, often fueled by investor sentiment and inflows.
Government Shutdown: A temporary cessation of non-essential government services due to a failure to pass appropriation bills.

S&P 500 Year-End Target and Q4 Outlook

Scott Kroner, US Equity Strategist at Citi, maintains their S&P 500 year-end target of 6600, which was set in early August. At that time, this target was ahead of the Southside Consensus and implied a 5% upside. Although the market has since surpassed this, reaching 6700+, Kroner does not feel an immediate urgency to change the target.

Citi's strategy for the fourth quarter (Q4) involves anticipating volatility during the Q3 reporting period. While expecting "very solid results," there's uncertainty about whether there will be "sufficient upside surprise and estimate increases to support the action short term." Following this anticipated volatility, investors should be prepared to capitalize on a "typical year-end rally" as the Federal Reserve progresses further down its rate cut path.

Q3 Earnings Expectations and "Beat and Raise" Narrative

Regarding Q3 EPS growth for the S&P 500, expectations are currently around +8%. Kroner believes this number is achievable, possibly even slightly higher. However, he highlights a key difference from Q2: the Q2 results not only "beat" expectations but also included a "re-raise" of future guidance, which significantly supported the equity market. The current market pricing implies a "pretty aggressive" persistency of this "beat and raise narrative." This aggressive pricing suggests that it will be challenging to provide enough incremental positive news to sustain short-term price action, especially in sectors where much is already priced in.

Sector-Specific Calls and Adjustments

Citi has made specific sector adjustments based on this outlook:

Communication Services: Recently lowered to a market weight from a two-and-a-half-year overweight position. This tactical shift reflects concerns that too much positive news is already priced in, making it difficult to generate further short-term upside.
Technology and Semiconductors (Tech and Semi): Still viewed favorably and remain overweight.
Financials (Banks): Remain in "very good shape." For banks, the need is less for a "beat and raise" and more for a "persistence of just making or potentially beating the numbers."
Cyclical Part of the Market (e.g., Banks, Retailers): Citi is leaning more into these sectors for Q4, as they are more contingent on the "rate trajectory continuing to come down."

Kroner notes that while some areas of the market are still in good shape, others are "paying a lot more for future growth expectations."

Major Risks to the Bullish Call

The biggest risk to Citi's bullish outlook stems from the S&P 500's composition:

AI-Affected Market Cap: Roughly half of the S&P 500's market cap is considered "AI affected." The other half comprises "everything else."
Heightened Expectations in AI: Kroner expresses more concern about the AI-affected portion due to "heightened expectations." While he doesn't question the "persistence of earnings growth over the next several years" for these companies, the concern is about the "magnitude on a shorter term basis" and whether they can "continue to feed the momentum" that has been crucial to their performance.
Short-Term Volatility: Citi is being more sensitive to "shorter term volatility risk" anticipated during the quarterly reporting period, despite strong longer-term fundamentals.

Consumer Spending and Cyclical Sectors

Discussions with clients frequently highlight labor conditions and valuation as key concerns. While acknowledging potential short-term issues with consumer sentiment and spending patterns, Kroner believes the "upper half of the income distribution is still in very good shape" and will "end up driving the retail bus" into the holiday season. This supports their tactical lean into cyclical sectors like banks and certain retailers, which are expected to benefit from a declining rate trajectory.

Alternative Investments (Alts) as Hedges

Citi's team (not Kroner personally) has a positive forecast for Bitcoin and Ether into late 2026, viewing them as continued follow-through assets. In the context of a "very aggressive momentum driven equity market," investors are seeking hedging opportunities. Alongside central bank gold buying, gold and crypto are seen as "hedges of choice" for navigating an "ongoing strength, highly valued but momentum driven equity market."

Government Shutdown Impact

Kroner has been "brushing past" the government shutdown, viewing it as "temporary." He expects that as the Q3 reporting period unfolds, the focus will shift back to "traditional fundamentals" and less on the shutdown's influence. However, he acknowledges that "the longer this goes on, the more it's going to have a tag on influence," though he is not in a position to predict the speed of a resolution.

Conclusion

Citi's US equity strategist, Scott Kroner, maintains a cautiously optimistic outlook for the S&P 500, anticipating a year-end rally after potential Q3 reporting period volatility. While long-term fundamentals remain strong, particularly in AI-affected sectors, short-term tactical adjustments are being made due to aggressive market pricing and heightened expectations. Key risks include the ability of high-growth sectors to continually "beat and raise" expectations, while cyclical sectors like financials and certain retailers are favored given an anticipated declining rate trajectory. Alternative assets like gold and crypto are highlighted as important hedges in a momentum-driven, highly valued equity market. The government shutdown is currently viewed as a temporary distraction, though its prolonged duration could increase its market impact.