"October is historically a turnaround month, where the markets tend to turn around after weakness but often the weakness carries on into October. Maybe, we have to get to the middle of the month—until we get some Chinese data and then we turn around. We think stocks are probably headed higher from here to year end," said Jeff Kleintop, senior vice president and chief global investment strategist at Charles Schwab.
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October is a critical turning point for Fed policy and in a highly choreographed wind down, the Fed Oct. 29 is expected to announce it is finishing its quantitative easing—the controversial bond buying program that many strategists say has added liquidity and helped provide a strong backdrop for stock market gains.
The Fed then begins a slow walk toward its first rate hike sometime next year, so each piece of economic data is even more important than usual since that is what is guiding the Fed's hand.
"This is the first time in years that we're looking forward to the next year, and people are starting to think about allocations and investments ... and you're highly confident you're facing an interest rate hike," said John Briggs, head of cross asset strategy at RBS. Briggs said the market's "buy the dip" mantra may no longer stand. "We don't know what kind of rate hike cycle we'll see, but we're fairly certain it's going to begin next year."
While strategists see potential bumps for stocks as Fed policy shifts, they also mostly see a higher end to the year.
Economists mostly expect the first Fed rate hike in midyear 2015, but that could shift depending on the economy. That puts the onus on U.S. data, starting this Friday with the September employment report, expected to show 225,000 jobs were created and an unemployment rate, barely changed at 6.1 percent.
JP Morgan chief economist Bruce Kasman said October data will be a critical stage setter for the fourth quarter, following on two positive quarters for U.S. growth after the first quarter's dismal weather-related slump.
"We're turning to the fourth quarter, which is an important quarter as to how its playing itself out...The issue now is do we sustain the momentum. We've had a good run and I think it's impressive how the U.S. has held up through the late summer," he said.
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Kasman said he is watching to see how much a lift the consumer will get from lower inflation, largely due to lower gasoline and other energy prices, and whether there is weakness coming into the economy from overseas.
"I'm concerned with the fact that we've had three times in this expansion growth pick up for a couple of quarters, and each time it's turned back over," he said. "We want to see if something new is kicking in here, as we go into the fourth quarter."
A highlight of the third quarter has been the strong performance of the U.S. greenback, with the dollar index up nearly 8 percent—its best quarterly gain in six years. The dollar has ridden the tail wind of a better U.S. economy, compared with weakness in Europe, Japan and China—and it has made strong strides against the euro and the wilting Japanese yen.
It is now also making gains against emerging markets currencies, some of which are especially hurt by the direct hit their commodities dependent economies are taking from the stronger dollar.
The dollar has also risen, while Treasury yields have stayed relatively low, amid a quarter rife with geopolitical events—any one of which could impact markets. The sanctions against Russia for its actions against Ukraine continue to be a worry for the weakened European economy.
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Air attacks by a U.S.-led group on Islamic extremists in Iraq and Syria have not affected energy markets, but traders are watchful for any impact. This week's demonstrations by citizens seeking democratic elections in Hong Kong raises longer term questions about a simmering political issue in China and reforms there.
Markets have also reacted negatively to success in the polls of incumbent Brazilian President Dilma Rousseff, who is running against Marina Silva, a candidate seen as a stronger proponent of reform and growth policies.
"There are a lot of things that are happening around the world right now that don't add up to a macro story, but do run some risks of turning into something under certain circumstances," Kasman said.
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The dollar strength is expected to continue, and it could be a headwind for some markets in the fourth quarter. Strategists point to oil, with Brent down 15 percent in the third quarter, and gold, down more than 8 percent.
October kicks off Wednesday with a series of other important reports, including ISM manufacturing data, construction spending, ADP private payroll data, and September auto sales.
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Kleintop said the risk in Friday's jobs report is that it shows a pickup in wage inflation. "That's something the hawks would jump on right away and say there's a more robust labor market," he said. A stronger labor market could push the Fed to raise rates sooner.
While he expects China data to surprise on the upside, Kasman said the risk is China will surprise to the downside. "We're focused on the U.S. and China as the two big drivers. One delivering upside surprise, and the other delivering downside surprise," he said.
One positive for U.S. markets could be the corporate earning season. Alcoa reports Oct. 8, and major banks release earnings the following week.
"I think the expectations are pretty low—6 or 7 percent. I think we'll hit that and probably exceed that. I think you'll hear from some companies about what's going on overseas. Things are a little weaker but some of the consumer oriented companies in the U.S. will say things are looking better," said Kleintop. "I think the real catalyst is more around what's going on in Europe."
Kleintop said the expectations of double digit earnings growth for European companies, however, appear overly optimistic and could be a problem for markets.