EQ: The third quarter of 2011 marked one of the worst quarterly performances for the market since the start of this recession. Based on how much the S&P 500 fell, is the market in oversold territory right now?
Stovall: History would tell you that it is. If you go back to 1945, we have seen nine times in which the S&P 500 fell by 10 percent or more in the third quarter. That actually spelled relief for investors in the fourth quarter because in eight of those nine times the market advanced. Using all nine observations, the average price change of was a gain of 7.2 percent gain. So, I think the recent relief rally is the result of a lengthy period of selling by investors in which we came very, very close to a new bear market. The news really hasn't changed, it's continued to be fairly bad whether you look to Europe and the sovereign debt problems or you look to the potential of a double dip recession here in the States. What's causing the uncertainty has not changed.
EQ: Investors may take some comfort in knowing that historically, the market does perform quite well in fourth quarters. Can you talk about why that might be or reasons why it has happened in the past?
Stovall: If you go back to World War II, the average price change in the fourth quarter excluding dividends for the S&P 500 has been a gain of 3.7 percent, which looks very good when compared with the average gain of 0.7 percent in the third quarter. Some reasons for why the market does fairly well in the fourth quarter is we start at a pretty low point because on average going back to 1990--looking back 20-some odd years--we've actually fallen in the third quarter. September is by far the worst month of the year, declining on average whether you look back at 1990, 1970, 1945 or even 1929. So when you come off a pretty negative month and a lackluster quarter, it then sets you up for the potential of an advance in the fourth quarter. Also, once you head into the fourth quarter, investors pretty much stop looking towards the remainder of the year and start looking into the new calendar year. So instead of focusing on two earnings reports ahead, or six months worth of fundamental data in the period ahead, they look to a year and quarter ahead. This is why investors can begin to get more optimistic because they have so much time between now and when we might be disappointed once again.
Another thing to consider is budgets. You have something called a budget flush, where if you don't use what's been budgeted to you, then you'll probably see your budget cut next year. This is especially found in the technology sector, but I think other sectors probably have the same experience where if you don't use it, you will lose it. This means we end up seeing a bit of an increase in business activity as business managers sell what was allotted to them, and therefore help to push share prices higher in the final quarter of the year.
EQ: In your latest Sector Watch report, you stated that the rising Q4 tide historically lifted all boats. With that said, which sectors usually performed the best?
Stovall: Past performance is no guarantee of future results, but I like to use history as a guide, but I acknowledge that it’s certainly is never gospel. Going back to 1990, none of the 10 sectors in the S&P 500 posted an average decline over that time period of 21-plus years. Energy was the weakest performer, posting an average increase of only 1.9 percent and Utilities were second weakest at a gain of only 2.7 percent. But if you look to some of the cyclical sectors, they were very strong. In particular, Technology was the strongest performer, up 6.9 percent, as compared with the market's average increase of 4.7 percent. Then we see that Consumer Discretionary did well, up 6.0 percent. But a little bit of a surprise is Consumer Staples--a defensive sector that was up 6.4 percent--among the top three performers on average in the fourth quarter.
EQ: Assuming that the fourth quarter is favorable to the market, you still think that there's a 75 percent chance that we are back into a bear market to start 2012. Can you shed more light on that?
Stovall: If you go back to WWII, we have had 12 bear markets and 18 corrections, which are declines of 10 percent to 20 percent. There were four of those corrections that saw declines in excess of 15-percent declines, making a total of 16 times that the S&P 500 fell 15% or more, with 12 of them (or 75%) eventually morphing into bear markets. So while four of the total 16 did not become bear markets, certainly 12 of the 16 did, thus implying that 75 percent of all market declines in excess of 15 percent eventually became bear markets. Let's face it, a bear market usually starts out as a pullback (a decline of between 5 percent to 10 percent), then becomes a correction (10 percent to 20 percent), and then only once it eclipses that 20 percent threshold can it be labeled a bear market. Therefore, that's how I come up with the 75 percent possibility that this market decline that we've experienced so far is still a correction, because it's down 19.4 percent and not down far enough to be called a bear market. However, I still believe that the chances are still very high that it will become a new bear market.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer