Troubled Market Pins Its Hopes on a Rebound in the 4th Quarter

Wall Street has gotten used to ending the year with a rally. Many investors may feel they need one now more than ever.

The major stock market indexes have just finished five straight down weeks, lopping 6% off the Dow Jones industrial average, 7% off the Standard & Poor’s 500 index and 21% off the tech-heavy Nasdaq composite index.

All three indexes also are in the red for the year to date--threatening to make 2000 the worst year for stocks since 1990.

The market has been tormented by a host of worries since August, including soaring energy prices, the weak euro currency and uncertainty over the extent of the U.S. economy’s slowdown.

Many of those woes appear to be hitting U.S. companies where it hurts: The driving force behind the declines in many stock sectors--especially technology--has been a surge in the number of companies warning that third-quarter sales and/or earnings won’t meet expectations.

Now, earnings reporting season is about to begin in earnest. Wall Street pros are wondering whether those reports will trigger a rally, or a final selling wave that could set the scene for a rally in November and December.

Either way, if the market has already reached or ultimately reaches a bottom this month, it would be one of many Octobers in which that has happened.

In fact, the current bull market began 10 years ago this week, when the Dow index bottomed at 2,365 on Oct. 11, 1990.

Those who think the bull is still healthy on its 10th anniversary argue that the recent damage isn’t as pervasive as it might appear from a glance at a glamour index like Nasdaq.

It’s the flip side of an argument that was made eight or nine months ago when Nasdaq was soaring. Skeptics said the index was so dominated by mega-capitalization stocks such as Microsoft, WorldCom and Dell Computer that it masked the weak performance of much of the rest of the market.

Now, with those three stocks wobbling near two-year lows and some other former Nasdaq leaders in the same boat, the optimists say the index overstates the downturn.

Indeed, money managers who have turned toward smaller stocks and more value-oriented names have been beating the big indexes for months.

“There are a lot of cheap stocks in the market--a lot of 10% to 12% growers with a 2% or 3% [dividend] yield selling at 12 or 14 times earnings,” said Stanley Nabi, vice chairman of DLJ Asset Management. “They just aren’t very exciting by some people’s standards.”

But the tech sector, Nabi said, could be threatened with more selling in November and December if consumers’ holiday spending is sub-par. Not only would Internet retailers get hammered anew, but the suppliers of Net equipment and services--Sun Microsystems, Cisco Systems and Oracle, to name three--could also be derailed, he said.

A more immediate problem for the market may stem from an accounting issue. For many stock mutual funds, their fiscal year effectively ends Oct. 31. Many funds may decide to unload losing stocks this month to generate tax losses to offset realized capital gains.

Heavy fund selling of already beaten-down stocks could shake investor confidence still further, experts warn.

David Webb, an executive of Cleveland-based Shaker Investments, thinks October tax-related selling by mutual funds will be a major event because of the way this year has turned out.

As Nasdaq skyrocketed early this year, “there was plenty of opportunity for money managers to book gains,” he said.

Since March, the Nasdaq index is down 33%. The worst thing a fund manager could do in a year of dismal returns would be to add insult to injury by handing investors a big tax bill from paid-out capital gains, Webb said. Therefore, the funds will be especially keen this year to grab some short-term capital losses to offset realized gains, he said.

That selling could create a bottom for the year, followed by a sharp rally in November and December, Webb said.

But he worries that if a rebound fails to materialize by year’s end, it could be a sign that the economy is headed toward recession.

“The markets have an uncanny ability to sniff out things that literally haven’t happened yet,” Webb said.

Even if a rally does start in the fourth quarter, it won’t necessarily involve the whole market, some pros say.

In terms of stock-picking, “We have the rifles out now. Before, it was the shotguns,” said Stephen Humphrey, manager of the Lord Abbett Large-Cap Growth Fund.

His fund remains tilted toward technology but in areas where he thinks the continuing expansion of the networking and communications infrastructure will survive an economic slowdown.

The revaluation of much of the tech sector--personal computers, semiconductors, Internet retailing--is an ongoing and appropriate response to unrealistic expectations built into the stocks early in the year, Humphrey said.

“It hasn’t been a good year [for many stocks], but in a way, that’s good,” Humphrey said. “It’s been a constructive year” in terms of moving the market back to reality.

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Saved by the Fourth Quarter?

The Nasdaq composite index rallied in the fourth quarter in eight of 10 years in the 1990s. But in the late 1980s, losses were the norm for the index in the fourth quarter.