Stock bulls like chances for strong 2014 finish

Odds are that the stock market will have a pretty good fourth quarter, but it's almost certain to be a volatile one.

The third quarter ends Tuesday, with the Nasdaq outperforming with a more than 2 percent gain, and the small-cap Russell 2000 lagging with a more than 6 percent loss. The Dow was up 1.4 percent for the quarter, and the S&P 500 was up about 1 percent.

Monday's market was rocky, with stocks losing more than a percent, before erasing the steepest losses. It is the eighth of 10 days, in which the Dow has had a triple-digit move in either direction. The Dow finished the day down 41 points at 17,071, and the S&P 500 was off 5 at 1,977.

Trader on the floor of the New York Stock Exchange.
Adam Jeffery | CNBC
Trader on the floor of the New York Stock Exchange.

"As the market gets more expensive, the uncertainty around some of these geopolitical issues is ... enough to get these selloffs. I do think underneath, it may be the Fed. It's hard to disentangle this. There is the hawks-versus-doves fight, but I do think the doves have the battle well in hand," said Bill Stone, chief investment strategist at PNC Wealth Management.

Monday's worry du jour was the protests in Hong Kong, in which students and others were seeking democratic elections in defiance of a ruling from Beijing. There was also a sharp selloff in stocks in Brazil, where it appeared President Dilma Rousseff was winning re-election. Challenger Marina Silva is favored by financial markets, on the prospect that she might institute reforms that would result in economic growth.

"We seem to be fading into the end of the second quarter. We'll see what tomorrow brings," said Stone. "Maybe it's just as much that we got a little ahead of ourselves. You can point to different reasons for why it's selling off. It seems to be worries about the global economy. The U.S., you could argue is losing some momentum from the second quarter, but it's still running at about 3 percent."

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But many strategists do say the heightened volatility is a direct result of the winding down of Fed stimulus. The Fed ends quantitative easing this fall and is expected to move toward raising interest rates sometime next year. That has made the market even more sensitive to the idea that global growth may not be that strong, and Stone said his biggest worry is the weakness in Europe.

He expects stocks to gain another several percent in the final quarter, with the S&P 500 already up 7 percent year-to-date. But he does expect the market to remain hypersensitive to geopolitical risks. He expects cylicals to lead the market higher, with his favorite sectors technology and industrials.

Data on Tuesday include S&P/Case-Shiller home prices at 9 a.m. ET; Chicago PMI at 9:45 a.m. and consumer confidence at 10 a.m. Walgreen reports earnings before the bell.

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As stocks sold off Monday, the volatility also filtered through to the bond market, which saw a flight to quality trade drive yields lower. The 10-year yield was at 2.48 percent in late trading, as traders focused on falling equities and geopolitical uncertainty.

"One reason it could be volatile is we've had such a lack of volatility. if you believe in reversion to the mean, we have to go up," and with the Fed ending easing, "there's that much more uncertainty," said Sam Stovall, chief equity strategist at S&P Capital IQ.

History is on the side of stock market outperformance in the fourth quarter. "It's the beginning of the November through April period. The 'sell in May' goes the other way. We are entering the best six months period, where the average gain since World War II has been 15.3 percent and the frequency of advance is 94 percent," Stovall said.

The S&P 500 was up just under one percent for the third quarter to date, as of Monday afternoon. "There have only been three times when we had a gain of 2 percent or less…everything has been 2 percent or higher—or negative territory," he said. In the 20 percent of the time since 1946 that the S&P was just slightly negative or as much as 3 percent higher, the S&P has gained 3.8 percent in the fourth quarter and was higher 13 of 14 times.

Another bit of history: In the years when there has been a mid-term election, the S&P gains an average 2.5 percent in the fourth quarter since 1946, Stovall said.

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Bespoke looked at the S&P's performance back to 1928 and found that in years when it is positive by as much as 10 percent in the first three quarters, the S&P has gained an average 5.6 in the fourth quarter with a positive performance 87 percent of the time.