Are Stocks Primed for a Fourth-Quarter Run?

The third years of presidential terms have been great for stocks. So far, 2007 is falling short.

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When the Dow Jones industrial average closed at a new high of 14,087 Monday, the first day of October, many market watchers breathed a sigh of relief. The new record meant the equity market made it all the way through September—traditionally one of the worst months for stocks—without any follow-up to the credit catastrophes that sent stocks tumbling in August. (Thanks, Federal Reserve!)

With that rapid recovery, the Dow is now up 9.3 percent for the year, while the Standard & Poor's 500 has gained 8.6 percent. Not a bad performance, but not as good as a market historian might have predicted heading into 2007, the third year of a presidential term.

Since 1945, third years have been the best for stock investors, with the S&P 500 notching an average gain of 18 percent. (Fourth years are the next best, with stocks gaining 8.6 percent.) What's more, an impressive 93 percent of third years have finished in the black.

At first take, this phenomenon may just seem to be one of those crazy financial coincidences, like how the stock market usually rises after an NFC win in the Super Bowl. But there's actually a reasonable explanation. "The market typically does well in the third year since investors buy in advance of the anticipated benefits to the economy brought by the economic stimulus initiated by the sitting president in order to get himself or his party re-elected," explains Sam Stovall of S&P.

But, as Stovall also notes, "history does not always repeat itself." Indeed, the market has a long way to go this year to catch up to the historical trend and only three months to get there. Historically, fourth-quarter performance in third years is somewhat modest. While 73 percent of fourth quarters register gains, the average fourth-quarter return is 2.8 percent, compared with robust 7.1 percent and 5.3 percent growth in the first two quarters. "If the Fed continues to lower rates aggressively, I think that a 2.8 percent return may not be out of the question," Stovall says.

Data from the past 62 years seem to back up Stovall's prediction. Stock prices have risen 78 percent of the time after the Fed makes a first rate cut in a series, and since 1945, the S&P has risen an average of 12.3 percent in the first six months after a rate cut. The Fed cut short-term interest rates by half a percentage on September 18, after holding rates steady since June 2006. Strong employment numbers released today, however, have reduced the odds that another rate cut will come this month.

How much does another rate cut matter? The Fed rate cut may have only been icing on the cake. Market strategist James Paulsen of Wells Capital Management argues that the economy was already recovering even before the central bank took action. "The fact that tech stocks were doing well before the rate cut shows that the stock market had recovered," Paulsen says. "We're not seeing anything that you would expect if the economy was in calamity."

He also argues that big gains could be in store if the economy continues to muddle through the housing downturn. "If a crisis doesn't produce a recession, it leaves in its wake a rally cocktail due to lower yields, greater liquidity, and cheaper stocks."

Other analysts are more cautious. "I don't think we will end the year in the negative territory," says Jason Hsu of Research Affiliates in Pasadena, Calif. "But it does look like we will have an uninspiring third year with more volatility than usual."