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Stocks Face Turbulence in the Fourth Quarter

Investors are bracing for fresh shock waves in the fourth quarter from the old familiar trouble spots that have been hanging over markets.

A trader at the New York Stock Exchange.
Photo: Oliver Quillia for CNBC.com
A trader at the New York Stock Exchange.

The third quarter’s more than 6-percent gain surprised many analysts, who have been expecting a pullback due to any number of sources, including Europe’s unresolved debt crisis and the downshifting of the Chinese economy.

Now, as the U.S. election gets closer, more attention is being paid to the so-called “fiscal cliff.” The cliff is the slam the economy would feel from the expiration of Bush-era tax cuts and automatic spending cuts that could take effect Jan. 1, if Congress doesn’t act in its lame duck session. (Read More:Beware of a 25% Correction: Pro)

“The market wants to know whether things are going to fall apart or not,” said Ed Keon of Quantitative Management Associates. “Meaning — Is China going to really have a hard landing? Is Europe going to break apart? Is the U.S. budget problem going to result in a horrible spectacle in Washington, with the same kind of tremendous uncertainty we saw in the debt ceiling debate? Those are things that would have major economic impact and a major impact on earnings.”

Stocks on Thursday got a lift after Spain disclosed its new budget with reforms that exceeded the recommendation of the EU. U.S. employment data was also a positive factor, with revisions from the Labor Department showing that 386,000 more jobs were created in the year ending in March than it originally had reported. Weekly jobless claims were also smaller than expected, at 359,000. But other data, like durable goods was disappointing, and the final reading of second quarter GDP showed sluggish growth of just 1.3 percent.

The Dow finished up 72 points at 13,486, giving it a gain of 4.7 percent for the quarter. The S&P 500 was up 13, at 1447, and it is up 6.2 percent for the quarter. The Nasdaq gained 1.4 percent Thursday to 3136, for a gain of nearly 7 percent for the quarter.

Friday brings the quarter end. There are several pieces of data, including personal income and spending at 8:30 a.m. ET, Chicago PMI at 9:45 a.m. and consumer sentiment at 9:55 a.m.

“I think the story of this year has to be this is the quietest bull market in history. We’re up 20 percent from last year and everyone is still nervous. The main reason is the worst-case scenario has not occurred,” said Keon. “Earnings data is pretty good. Stocks are pretty good value compared to other asset classes. But the market is just petrified that someday the worst case is going to hit and we’re going to have another downturn.” (Read more:September Bad for Stocks? Why It's Different This Time)

That worst case could be the fiscal cliff. Goldman Sachs analysts predictedearlier this week that stocks should fall sharply in the fourth quarter when investors realize there’s a possibility the fiscal cliff issues may not be resolved smoothly. They see a one-in-in three chance that Congress will fail to address the issues. They also see the S&P at 1250 at year end.

Other strategists are also treading with more caution. Harris Private Bank CIO Jack Ablin said the S&P has already hit his year-end target of 1450, and he’s been playing defense heading into the fourth quarter.

“I think we could be flat to down,” said Ablin. “I’m getting a tense feeling here.”

Ablin said he would consider adding more defensive type holdings, like preferred stocks and Master Limited Partnerships. “We have no Europe, no small caps. We do have emerging markets and within the large cap stuff, we’re growth and quality with a little dividend bias,” he said.

The Fed’s latest policy moves, an open ended-third round of quantitative easingand the promise of a longer period of low rates, set the stage for the market’s third quarter advance. But analysts question how much more lift it can continue to give stocks.

“I’m tempted to watch from the sidelines, but we’re not going to cash and we’re not going to bonds,” said Ablin. “Essentially, we’re going to downshift our market exposure from long-only stuff to income-oriented stuff.”

Keon said the economy’s bumpy performance is nagging at investors. “Investors are trying to figure out, ‘is it weak and getting worse? Or is it getting a little better?’ I think it’s weak and maybe getting slightly better, and the reason I think that is I think the recovery in the U.S. housing market is for real,” he said.

He said the Fed’s new QE program, aimed at mortgage securities, could also help by keeping pressure on mortgage rates and encouraging banks to underwrite more mortgages with the Fed a ready buyer.

Washington is expected to approach the fiscal cliff differently, depending on who wins the White House in November. But Keon said the election outcome itself probably won’t impact the market, it’s more the actions of elected officials later. Keon said he believes whoever — President Barack Obama or Republican Mitt Romney— would be more willing to compromise with Congress, to avoid the cliff and resulting recession.

“Just as a matter of historical fact, it doesn’t matter much who is in office whether it’s a Republican or Democrat. A lot of people think the market will do better if a Republican is elected but that hasn’t been the case historically,” he said. “No matter who wins this, it’s (fiscal cliff) is going to be one of the first things they have to deal with.”

The fourth quarter also brings third quarter earnings reports starting in October, and those numbers are expected to be weak. But if this quarter is like previous quarters, the positive surprises could surpass the negative and that might help stocks, said Keon.

And, there are also the ongoing geopolitical concerns, particularly Iran’s nuclear program.

Israeli Prime Minister Benjamin Netanyahuspoke at the United Nations Thursday, warning a “red line” needs to be set to prevent Iran from developing nuclear weapons. The U.S. has resisted putting a deadline on Iran, and President Obama this week told the U.N. that Iran does not have unlimited time.

Iran’s ability to sell oil has been limited by an embargo and economic sanctions. Netanyahu’s comments propelled oil higher Thursday, with West Texas Intermediate crude reaching $92, a 2 percent gain.

John Kilduff of Again Capital said the trend for oil, however, is lower, unless the situation with Iran heats up and it threatens oil shipments in the Strait of Hormuz. “The economic data continue to point to diminishing oil demand, not increasing, which should allow prices to fall into the low $80s for WTI,” he said. (Read more:Why Oil Prices Are Likely to Decline Further)

Follow Patti Domm on Twitter: @pattidommQuestions? Comments? Email us at marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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