Week Ahead: Stock Markets May Close Q3 With A Gain

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Includes: DIA, IWM, QQQ, SPY
by: Chandrasekhar Rajagopalan

Stock markets are likely to close higher in the third quarter following the stimulus-induced extended rally. However, the coming week could see selling pressure coming in to lock profits at higher levels. The markets could not hold on the initial gains till the week was over on September 21. The Dow Jones Industrial Averages or DJIA slackened 0.1 percent, while S&P 500 and Nasdaq dipped modestly by 0.38 percent and 0.13 percent respectively during the week. Still, the markets could close the third quarter with a gain barring any unforeseen negative sentiments hurting the stocks.

Of the three quarters in 2012, second quarter is the only quarter to suffer loss. This is probably due to a significant gain recorded in the first quarter necessitating corrections in the second quarter before an uptick. Since the end of 2011, S&P 500 gained 12.0 percent in the first quarter, whereas Nasdaq advanced 18.7 percent and DJIA edged up by 8.1 percent. However, the second quarter witnessed S&P losing 3.3 percent, while Nasdaq and DJIA were down by 5.1 percent and 2.5 percent respectively.

The primary reasons for the markets to record gains in the third quarter are the improvements in the housing market, nonfarm pay roll and the jobless data braving the continued uncertainty in the global economic conditions. More than any positive data to drive the markets, there were less negative sentiments from the economic indicators thereby allowing the markets to close in the green.

The S&P 500 had already recorded 7.2 percent gain in the third quarter based on the closing price of September 21, while Nassdaq and DJIA advanced 8.3 percent and 5.4 percent respectively. Technology bellwether Apple's (NASDAQ:AAPL) stock performance is incredible. The stock jumped 73 percent in 2012 based on the closing price of September 21 and a significant contributor to all the indices' growth. On the other hand, Google (NASDAQ:GOOG) advanced only 13.6 percent, which is below the S&P 500 gain. Similarly, International Business Machines (NYSE:IBM), Microsoft (NASDAQ:MSFT), General Motors (NYSE:GM), KB Home (NYSE:KBH), Pulte Group (NYSE:PHM) and Exxon Mobil (NYSE:XOM) have gained 12.0 percent, 22.4 percent, 127.1 percent, 169.1 percent and 8.3 percent respectively. Boeing (NYSE:BA) is a big disappoint as it had lost 4.9 percent in 2012 based on September 21 price. The markets also reacted favorably to the QE3 announced by the U.S. Federal Reserve. Bank of Japan followed it by increasing the size of its QE program.

The following week will also provide data on consumer confidence, new home sales and durable goods order to guide the market. While Wells Fargo sees positive data on consumer data and new home sales, durable goods order likely to be in the negative territory. Even if all the economic data fail to impress the markets, the downside risk is not likely to be more than 20 - 40 points from Friday's closing of 1,460.15 based on S&P estimation.

Looking at the third quarter earnings, S&P Capital IQ expects S&P 500 earnings per share to fall 1.8 percent year-over-year. However, the companies are likely to exceed a low bar again; S&P wrote in a research note on U.S. investment policy committee notes on September 19. This suggests that both the results and guidance are likely to be subdued.

Interestingly, 21 companies in the S&P 500 component provided negative earnings outlook for the third quarter and only 21 companies issued upbeat earnings guidance, according to Factset Research Firm's earnings insight. They have also predicted earnings growth rate of a -21 for the third quarter with the Energy and Materials bearing the brunt by 21 and -21 respectively. However, financial sector is seen to record highest earnings growth rate of about 21.

Meanwhile, S&P also cautioned that in a week or two S&P 500 is likely to come down to 1,420 - 1,440 levels based on technical. S&P further commented, "Following this projected pullback, we expect the next leg of the advance to begin, with the S&P 500 heading up to the all-time highs seen in 2000 and 2007 in the 1,550 - 1,580 area by late this year or in Q1 2013. A measured move based on the completed cup-and-handle formation targets the 1,577 level".

The 10-days trading pattern indicates that S&P 500 is witnessing a selling pressure after hitting a record high of 1,474.51 points on September 14. However, support came in around 1,450 - 1,460 levels. If the selling persists to take advantage of locking profits at higher levels, the index could come down first to 1,440 and then to 1,420 levels, where S&P expects support to spike a fresh bull run.

S&P also looks forward to PE expansion to drive the markets higher as the macro uncertainty keeps receding from the sky high levels. The research firm attributed the last 100 points gain in S&P 500 to PE expansion and not the EPS growth.

Meanwhile, optimism about the third quarter earnings among the analysts seems to have improved. Though the EPS estimate index improved to 21 on September 21 from 21 on August 24, the index stood at 21 on June 29, according to Factset. This only suggests that uncertainty fear started receding in the last one month. However, correction looks imminent given the last week's trading pattern, while the outlook for the fourth quarter holds key to further uptick.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.