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Stocks Seen Rising Further In Volatile Fourth Quarter

Stocks are likely to see further gains in the fourth quarter, though the ride may be bumpy at first.

The year's final quarter, which begins Monday, is traditionally the strongest period for stocks. But there are plenty of reasons why the gains may be held in check this year: continued uncertainty in the credit and housing markets, a plunging dollar, higher oil and the specter of a U.S. recession.

As a result, the markets may well start the quarter on a down note, says Todd Clark, director of stock trading at Nollenberger Capital Partners.

"I'm seeing a slew of potential negative divergence in the market," Clark says. "There is an incredible lack of 52-week highs compared with new lows. The breadth of the market hasn't been impressive during the (recent) rally. Negative divergences could haunt the market."

"October is usually volatile, but we may see a rally in November or December," adds Charles Rotblut, senior market analyst at Zacks.com. "I think we'll end the year a little bit higher."

Strong Third Quarter

Thanks to the Fed, stocks ended the third quarter on an upbeat note. After the markets plunged in August amid a crisis in the credit markets, the Federal Reserve came to the rescue in mid-September with a deeper-than-expected cut in interest rates.

The Dow Jones Industrial Average ended the quarter up 3.6%, a solid performance considering that the blue chip average had plunged 8.2% in mid-August from its record high on July 19.

The technology-rich Nasdaq Composite performed the best, rising 3.8% in the third quarter. The broader S&P 500 index did not fare as well, eking out small gain of 1.6%, but still an impressive recovery from its mid-August lows.

Where stocks go next, of course, will depend a lot on what the Fed does about interest rates. But since the central bank doesn't meet until late October, the market is likely to be volatile for the next few weeks.

Still, some market pros see that as a buying opportunity.

"Look for the pullback in the first two weeks of October and jump on it hard," says Marc Pado, chief market strategist at Cantor Fitzgerald. "I think we're going to have a strong finish to the year."

The fourth quarter is far and away the best for investors, outperforming the other quarters by a more than two-to-one margin, says Sam Stovall, chief investment strategist at Standard & Poor's.

"You have a lot of cash infusion," he adds. "Investors focus on the coming calendar year and let this year go its own way."

Where to Invest

Tech stocks continue to be among the favorite plays for the fourth quarter. "It clearly has the most momentum of any group," says Nollenberger's Clark.

Adds S&P's Stovall: "Technology is one of the best performers this year and is up about 9% on an annual average since we introduced it in 1990, outperforming the market about 60% of the time."

Investors should also focus on food producers such as H.J. Heinz or farming equipment makers like John Deere , as a step-up in ethanol production has resulted in rising food costs, says Zacks.com's Charles Rotblut.

"These companies have pricing power and have the ability to pass along the higher costs of food," he explains.

Aerospace companies such as Boeing and others should also fare well, says Rotblut. "Economic growth is stronger abroad and a lot of airlines there are investing and upgrading their fleets," he said.

In addition to Boeing, which has a multiyear backlog in orders, parts makers such as Precision Castparts and Triumph Group should also benefit from the upgrade cycle.

"We expect them to see sustained growth over the next two years at least," says Rotblut.

Two Pharma Stocks

Johnson & Johnson is one stock that looks cheap at current levels, according to Peter Klein, senior portfolio manager at Fifth Third Asset Management.

"We like it because it's a low-expectation, undervalued security at this point," he says. "If you look at what's happened over the past seven years, it's doubled its earnings and its dividend and is selling at the same price a was in 2001. It is certainly undervalued at 14 times earnings."

Another pharmaceutical stock the money manager likes right now is Barr Pharmaceuticals, a company that focuses on the generic drug market.

Klein says the company's recent takeover of European generic drug manufacturer Pliva will help Barr get its foot into the European market, gives it low-cost manufacturing capabilities and opens the door to manufacturing generic biotech drugs.

"I think we're going to see that the opening up of European markets will be a big boon for Barr," Klein says.

Peter Kang is a markets writer for CNBC.com and can be reached at peter.kang@nbcuni.com.

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