The Potential Market-altering Events in the Fourth Quarter

Potential Market-altering EventsWe are entering the always intriguing fourth quarter, during which I expect to see some major surprises that could alter the current investment and political climates and increase the stock market risk.

The Dow Jones Industrial Average and the S&P 500 have recorded four straight months of gains, yet the stock market risk remains high, given the strong advance this year. Blue chips and large-cap stocks showed decent buying in September with technology trailing. For the year, the NASDAQ continues to be tops with a 19.6% advance, followed by the S&P 500 at 14.5%. The Dow is trailing at just under 10.0%.

The key event with the most stock market risk at this point is the uncertainty of the presidential election on November 6, when President Obama will try to extend his policies into a second term. But on January 1, 2013, the country will face the potential “fiscal cliff,” when the terms of the Budget Control Act of 2011 are scheduled to go into effect, resulting in automatic spending cuts across the board and tax increases. The problem is that cutting fiscal spending at a time when economic renewal is still fragile is risky; it could hamper the impact the Federal Reserve’s third round of quantitative easing (QE3) might have on the U.S. economy and could add to the stock market risk.

Federal Reserve Chairman Ben Bernanke reiterated his support for QE3 and said that the easy money will be available even as the economy recovers. The fear is the easy money could drive up inflation, and in reality, it is more of a vehicle for the wealthy.

On the domestic front, the number of new durable goods orders was horrible, declining 13.2% in August, versus the -5.0% estimate and the -4.1% in July. On an ex-transport basis, durable goods fell 1.6%, again worse than the -0.2% estimate and revised -1.3% in July. The poor reading indicates hesitancy in spending on non-essential goods and services that, in my view, is a key component of a healthy and growing economy.

Second-quarter GDP growth (third estimate) reflected the current stalling in the U.S., as the growth of 1.3% was well below the estimate of 1.7%.

In addition to the economic bumps, there is also nearly $16.0 trillion in U.S. national debt and deficit levels (read “We Can’t Ignore It: America’s Going Broke”), which adds to the stock market risk. And while this is going on, you have about 13 million Americans looking for work and probably about 25 million Americans who are unemployed or underemployed. We are seeing more major companies slash jobs to compensate for the lower business volume.

Over in the eurozone, a stress test on Spanish banks showed that less capital was required than initially estimated. Spain adopted aggressive austerity measures, focusing on cost cuts rather than tax increases that helped to add some much-needed optimism to the eurozone. While this is a start, the eurozone remains high-risk and will likely enter a recession in 2013, which will add to the stock market risk.

The upcoming third-quarter earnings season is expected to be weak on both revenues and earnings, adding to the stock market risk. Overall revenue growth is estimated to be flat, down from 1.9% growth at the start of the third quarter, according to FactSet. This is not what you would expect if the economy was healthy, and it indicates stock market risk. And while there is some hope and optimism for the third quarter, I expect disappointment across the board.

Based on the current estimates, corporate earnings for the S&P 500 are estimated to fall 2.6% in the third quarter, which would end the 11 straight months of earnings growth, according to FactSet. So far, for the third quarter, 82 S&P 500 companies have issued negative earnings-per-share (EPS) guidance, while only 21 companies are reporting positive guidance; this adds to the stock market risk.

While the stock gains are positive, I continue to feel that traders are somewhat lackluster in their assessment of the current stock market risk.