Will the market rally this fourth quarter as it has every Q4 since 2002?. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary The stock market closed out the month of August with a gain of 2.4%. This is good news. But you wouldn't get the impression that there is any happiness on Wall Street or on Main Street. Investor sentiment gauges are at some of their most negative levels in a long time. Trying to find bright spots for the market is no easy task. The best news may be the abundance of fear that seems to be embedded in the market's psyche. This could set us up for our fourth fourth-quarter rally in a row. Unlike past fourth-quarter rallies, which were aided by better-than-expected corporate earnings, this fourth quarter rally may need more solid evidence that inflation is not just decelerating but declining.

Review and outlook

As a loyal son of the Land of Steady Habits, Conn., my emotions tend to stay in a fairly narrow channel. But I must admit that during this past month my emotions have tested the lower bound of that range. The news flow, particularly out of the Middle East, is anything but reassuring. Investment-market news has been mixed. Oil prices rose, then receded slightly. The economy is slowing, raising fears of a recession. The acceleration in inflation, however, seems to have abated over the month as a result of a slowdown in overall growth. Corporate earnings posted another stupendous quarter, but the outlook for continued better-than-expected news over the next quarter is the cloudiest it has been in a while. This uncertainty doesn't make me feel particularly cheerful.

Fortunately, poor investor sentiment is a strong positive for the stock market.

As measured by the S&P 500, the U.S. stock market fell 0.9% last week, with industrials, telecoms, and financials recording the most negative returns. The upside leader for the week was energy, which benefited from the news that British Petroleum would have to close a portion of its North Slope pipelines. Smaller-capitalization stocks, as measured by the Russell 2000, fell by more than 3% last week. International stocks fell by 1.6%. We have preferred international equities over domestic equities for quite some time. Thanks to both stronger local markets and currency gains, overseas markets have outperformed domestic large- and small-cap stocks. We have not favored small-cap stocks for some time now, thanks to fairly high valuations. While smaller-cap stocks did well in the first part of the year, their recent performance brings their year-to-date returns below returns for U.S. large caps.

For the month of August, the markets shrugged off this uncertainty and rose by 2.4%, as measured by the S&P 500. As measured by the S&P 500, the stock market was up 5.8% for the calendar year at the end of August. The small cap market got some of its mojo back, rising by 3.0% for the month. Finally, international markets more than matched domestic large caps with a 2.8% rise in August.

So, if the news on the geopolitical scene and the world was a little punk, what lifted the market? Perhaps a part of the market's rise can be attributed to the fact that some still unsettled issues did not get worse. There is, for example, a truce in Lebanon. Ernesto did less damage as a tropical storm than as a hurricane. Both less than disastrous outcomes helped to bring down oil prices. But a "less than disastrous" does not set the stage for wild euphoria in the markets.

In fact, fear and pessimism are pervasive in the market. As shown in the chart below, UBS' individual-investor-sentiment survey is at a very low level.

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The "smartest" money - managed by the hedge funds - also seems gloomy. According to the latest weekly ISI poll of hedge-fund managers, funds are at at their lowest exposures to the market since right after the ravages of Hurricane Katrina in the third quarter of 2005. Sentiment was also quite low going into the fourth quarter of 2004. In both cases, the market rallied in the fourth quarter. The same thing happened in 2003 and in 2002.

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What was the catalyst for these rallies? In 2004, many people cited the elections as a positive for the market. In 2005, the hurricane season ended without any more disasters. I'm not sure though that these were the real catalysts. I am more tempted to argue that the real catalyst was related to the level of caution that has been built into Wall Street since the Internet bubble collapsed. Since that low, investors have been pleased with earnings results.

Investor thinking over the last few years has gone something like this: Early in the year, they celebrate when earnings appear on track for the next twelve months. During the second and third quarter, fear that the party is ending creeps into the market. Concern begins to mount that next year's earnings will not be nearly as good as the current year. The market stalls. In the fourth quarter, the next year's results become more visible, and analysts and investors begin to acknowledge that the earnings story for the next year is still strong.

It would be nice if the same thing were to happen again. It is possible, but I think the scenario may end up playing out a little differently. Thanks to the slowdown in the economy, positive earnings surprises are less likely to happen over the course of the next quarter. The model we use to make these forecasts is indicating that the next quarter will produce fewer positive surprises. Positive surprises in the fourth quarter have given analysts the courage of their convictions to mark up their estimates for the next year.

So, are we going to fail to get a fourth quarter rally this year? A lot is going to depend on the Fed convincing investors that it has inflation under control. Federal Reserve chairman Ben Bernanke has succeeded in slowing down the economy. Slowing the economy is just the first stage. Whipping Inflation Now is the next stage. At this point, the best we can say is that the inflation rate doesn't appear to be accelerating. As of now, we are betting that the Fed brings the inflation rate under control over the next twelve months or so, and that the markets will rejoice. Whether it happens by the end of the year is less certain. -FWR

Review and outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.

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