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Stocks could fade after best month in four years

October is on track to be the best month for stocks in four years, but the rapid gains may have taken some steam out of any year-end rally.

The Dow and S&P 500 have both risen about 9 percent in October, the best monthly performance since the S&P's more-than-10.7 percent rally in October 2011. The strong October gains follow a steep decline in August into September, on worries about soft global growth just as the Fed looked set to raise interest rates.

"I'm not sure we really changed any fundamentals. So, I don't know if it's going to sustain," said James Paulsen, chief investment strategist at Wells Capital Management. "The worst thing that could happen now is that this global economy still has a weak feel, and in the midst of that you get a strong or hot wage number. We've got an ECI (employment cost index) number (Friday). If that's hot and the payrolls are hot, then the Fed and the markets are in a real tough place. You could challenge the recent lows."


Trader on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters
Trader on the floor of the New York Stock Exchange.

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The Fed this week changed the dynamic for a market that was rallying in part on the belief that the Fed was on hold into next year. The Fed Wednesday put markets on notice that a rate hike could be coming sooner, when it specifically indicated it could raise rates in December and detailed what it would consider in its decision-making process.

There are two more monthly employment reports before the Fed's December meeting, but the Fed, and markets, will be very sensitive to all employment and inflation related data released over the next six weeks. That would include things such as ECI data, reported at 0.6 percent Friday, a moderate pace. PCE deflator, the Fed's preferred inflation measure, was also reported Friday at a still sluggish 1.3 percent in September, over a year ago.

Stocks surged Wednesday after the Fed meeting, but traded quietly since. Stocks were slightly lower Friday. The S&P closed at 2,090 Thursday, and the Dow was down at 17,755. Based on Thursday's close, the S&P was up 1.5 percent year to date, and the Dow down 0.4 percent. Nasdaq was up 9.8 percent for the month of October so far, and 7 percent year to date.

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"My guess is we had the year-end rally, so to speak," said Paulsen. "I don't think we changed much of the forces that produced the correction in the first place… . The only thing that changed is investment sentiment." The sell-off turned bullish sentiment bearish, and now he said it is getting back to neutral.

"I think November is going to frustrate people," said Julian Emanuel, equity and derivatives strategist at UBS. "It's very typical in the professional community where you often see this performance chase in the fourth quarter. Even though you had this rally in October, there were literally no signs of performance chasing because the underperforming stocks outperformed and the winners got sold. For that reason, we don't think there's going to be a high degree of performance chase into year end to fuel a rally."

Emanuel said stocks could see a pullback and then move higher, but he expects more of a sideways move. His year-end target for the year is 2,125, so he does not anticipate a big move higher.

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Historically, traders expect a bottoming in any early fall sell-off during October, and then a seasonal move higher in stocks in November and December. Sam Stovall, chief equity strategist at S&P/Capital IQ, said the strong October rally may have stolen December gains.

"I'm still positive for November and December from a seasonal perspective. I'm just saying it hasn't been as strong as it has been, mainly because much of the fourth-quarter advance was already used up in October. I don't see it going down. I just don't see it going up as much as it usually does," he said.

Analysts said there could be a pullback in November, before a move higher as the market consolidates recent gains.

Stovall said going back to World War II, the average performance for the S&P 500 was a 3 percent gain in the November and December period, and it has been higher in that timeframe 77 percent of the time. But when the S&P was already up strongly in October, gaining 7 or 8 percent or more, the gains over the two months were reduced. He said the S&P 500 was still positive but just 60 percent of the time and its gains were just 1.9 percent.

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On the other hand, the best performance in November and December came after October declines.

November has been historically a strong month. The Dow has been positive 70 percent of the time in November during the last 20 years, for an average 2.4 percent gain, and only April has been a stronger month than November in that period, according to Bespoke.

Bespoke points out that 2015's market looks very similar to 2011, when the S&P 500 was up 10.7 percent in the month of October. The index then lost a half-percent in November, and gained just 0.3 percent for November and December.

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"It's a positive time of year for the equity market as long as you don't get a major disruption. The key would be the Fed in December. While the statement may have been a little more hawkish than some people were expecting, it seems hard to imagine that they will hike rates in December," said Paul Hickey, a co-founder of Bespoke. "The economic data we've seen in the last several days hasn't been necessarily bad, but it's been below expectations."

There are two Fed speeches Friday. San Francisco Fed President John Williams speaks at 10:50 a.m. ET, and Kansas City Fed President Esther Goerge speaks at 11:25 a.m. ET on Federal Reserve structure at a CityAge Conference.