Our Thoughts

What History Tells Us About Fourth Quarter Performance

Recently the Dow Jones Industrial Average met one of our criteria for a cyclical (short-term) bull market and it is something we are watching closely. As we’ve mentioned in previous, we are in the midst of a secular (long-term) bear market, but we are optimistic regarding a fourth quarter rally. But, let’s take a look using the S&P 500, a better barometer of overall market performance, instead of the Dow.

Historically, the S&P 500 has performed better in the fourth quarter than in the previous three with a median gain of 4.3 percent. Since 1924, fourth quarter performance has been even better (4.9 percent) following the 15 instances of a third quarter decline of 8 percent or more. But, fourth quarter outperformance isn’t inevitable and we are looking at two other trends to help us determine our equity outlook for the remainder of this year.

Recession

Right now, the specter of another recession is a key driver of whether or not the markets will rally in the next few months. For example, in 2008, the S&P 500 fell 23 percent during the fourth quarter with similar declines in 1930, 1931, 1937 and 1957. However, all five of these downturns occurred during a recession. Typically, in the six months following an 18 percent drop from market peaks during non-recessionary periods (like now), the S&P has been higher 80 percent of the time. So far, macroeconomic indicators we follow such as unemployment and manufacturing do not support the case for another recession.

1998 vs. 2008

It’s our opinion that the current economic climate is closer to 1998 than it is to 2008. During 2008, the U.S. was the focal point of a rolling financial collapse that sent the rest of the world into a global bear market. This period featured the worst stock market declines and foreshadowed the longest recession since the 1930s (it also precipitated the biggest earnings collapse in modern memory).

In 1998, the U.S. was on the sidelines when the so-called “Asian Contagion” hit Southeast Asia causing currency and market collapses, a liquidity crisis and general economic contraction. The Contagion in turn led to a drop in oil prices and ultimately to Russia’s default on its sovereign debt. Both of these events hastened the bailout (organized by the New York Fed) and eventual demise of Long-Term Capital Management, then one of the most well-connected hedge funds in New York.

During the current Eurozone crisis, the U.S. found itself watching from across the pond as the Greek sovereign debt problem appeared to be spreading to other countries such as Portugal, Ireland, Italy and Spain. The Eurosolution has been a series of Greco-bailouts put together by the European Commission, the European Central Bank and the International Monetary Fund, all guaranteed by the German government (much to the chagrin of the German people). We don’t yet know if a Greek default can be avoided, but for now, the situation looks more like 1998, when the U.S. was on the outskirts, than 2008, when the U.S. was the epicenter.

Summary

As long as the market continues to mimic 1998 instead of 2008, the likelihood of a recession this year will remain low. And as we’ve seen, fourth quarter performance during non-recessionary periods tends toward the upside. As always, we will be closely monitoring the situation and making appropriate adjustments to our portfolios.

NOTE:  Historical trends are only one data set we use to determine equity allocation in our portfolios. We also look at trading volume, market breadth, investor sentiment, valuation, and industry/sector performance, just to name a few.