Top Gun FP Client Note: The Case For A 4th Quarter Rally

I am going to go out on a limb and predict a 4th quarter rally for a number of reasons.

 

First, historically the 4th quarter is the best for stocks.  In the last 20 years, the S&P has returned an average of 4.57% in the 4Q compared to -0.37% in the 3Q, 2.30% in the 2Q and 1.02% in the 1Q. 

 

This might not seem like a good reason to be bullish but there is an important cause of this seasonality.  The stock market is controlled by the big money on Wall Street.  These guys are judged and paid based on their performance.  Therefore, they have a huge incentive to move the market higher at year end to pad their performance and bonuses.  In my opinion, this bias towards a year end rally has become even more pronounced as hedge funds – who take 20% of the profits – have become more and more important players in the market in recent years. 

 

Indeed, there have been Santa Claus rallies in each of the four full years I have been managing money professionally and the pattern seems evident on the charts for many years preceding as well. 

 

The one thing you can count on from Wall Street is that every stratagem to move money from your pocket to theirs will be utilized.

 

The second bullish factor is technical.  As I have noted in previous Client Notes, 1100 on the S&P is solid intermediate term support.  That was the low established in the wake of the S&P downgrade in early August when fear was high and volume heavy. 

 

With today’s close (Mon 10/3) at 1099, we are in the midst of a crucial test of that level.  Many traders have surely placed their stops just below 1100 setting up the possibility of a washout should they be triggered. 

 

We saw something similar on Tuesday August 9th when traders had placed their stops below 1120 – the low from the previous day.  When that level was taken out in the wake of the FOMC Statement, the S&P plummetted all the way down to 1100.  However, having cleaned out all those stops, it quickly rebounded and finished the day much higher.  1100 has been support since.

 

Third, valuations are supportive at these levels.  S&P 500 operating earnings over the previous 4 quarters were $91.  At 1100, that’s a 12.1 trailing multiple.  Many high quality, blue chip stocks are trading at even lower multiples.  Even if we enter a recession and earnings decline, my guess is that the real hit won’t come until 2012.

 

There are two scenarios that could derail a 4th quarter rally.  The first is the sovereign debt crisis in Europe.  If Greece defaults or there is some unforeseen adverse event, all bets are off.  For the moment, however, it appears that crisis has been averted.  Most of the 17 euro members parliaments have passed the EFSF expansion and Greece seems set to receive the €8 billion installment it needs to get through year end.

 

The other concern is 3rd quarter earnings.  If these come in much worse than expected, we may very well break 1100 on the downside.  However, analysts have already taken down numbers and expectations are muted. 

 

Both the decision regarding Greece’s €8 billion installment and 3rd quarter earnings will occur in October.  Even though we are in a bear market and I expect us to go lower in 2012, if we can get through this scariest of stock market months I think we are setting up for a reprieve through year end.