4Q Will Be Pivotal For Equity Markets

Includes: DIA, SPY
by: FP Trading Desk

The beginning of October means one thing to investors: the start of the fourth quarter. And not just any fourth quarter, either. This one will almost certainly prove to be a pivotal time for the stock market as some of the biggest investment themes of the past few years come to a head.

Those themes? They include the slowdown of the U.S. economy, the impact of rate cuts by the U.S. Federal Reserve, the influence of the U.S. housing downturn on consumer spending, the possible resolution of turmoil in global credit markets and the push and pull of the strong Canadian dollar on Canadian corporate profits.

For the most part, observers are cautiously optimistic about the outcome of these powerful moving parts, which may be reflected in the record-breaking close of the Dow Jones industrial average yesterday. But even optimists believe conditions amount to a delicate balancing act, which should make the next three months anything but smooth.

"There could well be considerable volatility in the months ahead," said Martin Barnes, managing editor of the influential Bank Credit Analyst. "But the path of least resistance is for equity prices to move higher."

He points to reasonable equity valuations, great corporate balance sheets, moderate global economic growth and the benefits of a new monetary-easing cycle, with the Fed expected to trim rates further in the months ahead.

In fact, the consensus view among observers is remarkably benign, given all the uncertainties. Consumer spending will get hit by the deteriorating U.S. housing market, but the United States should be able to avoid a recession thanks to strong employment rates. The credit markets will gyrate further, but liquidity will return. And as for Canadian profits, surging commodity prices will help nullify the impact of the strong loonie in some sectors.

But forget about taking these views as signals to buy blindly; in the near term the consensus has a habit of being challenged with unexpected news, even if it is proven right in the longer term.

For example, the housing downturn in the United States is essentially in uncharted territory because of its severity, which means no one is sure whether Fed rate cuts will revive the housing market or succeed in stimulating the economy.

As well, October is the month when a number of institutions will likely report the true value of their distressed investments -- especially complex investments involving packaged debt products that have been blowing up in unlikely places recently. Citigroup was first off the mark, yesterday writing down US$1.3-billion worth of securities backed by subprime mortgages.

"With the end of the third quarter comes the invariable mark to market valuations and reporting," said Stewart Hall, market strategist at HSBC Securities (Canada). "In other words, it's time to come clean, and for those looking at the potential for a few more snakes in the market space, it is anticipated that October is the month of reckoning."