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Looking for a Huge Fourth Quarter

Schaeffer's Senior Technical Strategist discusses the importance of respecting trends

by 10/8/2012 7:35:27 AM
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All in all, the market continues to defy the critics. We have maintained a bullish stance all year -- despite some concerns here and there -- and remain positive longer-term. But what will happen in October, and more importantly, the fourth quarter?

First, October has a bad rap as being a typically bad month, even though it hasn't been that bad longer-term. In fact, over the past 10 and 20 years, it's one of the strongest months! However, during the past five years, it's been down 0.60% -- putting it right near the middle of all months in terms of performance. There are some near-term concerns here, but at the same time, the overall trend is higher. While some traders may find it fun to try and pick tops, the data below suggests expecting a big down October might not be prudent.

Monthly Returns for the S&P 500 Index over a 5-Year and 10-Year Span
Monthly Returns for the S&P 500 Index over a 20-Year Span

J.C. Parets of AllStarCharts.com recently conducted a great interview with legendary technician Ralph Acampora. There are three parts to the interview, and you have to read them all. Ralph has been active on Twitter, calling for a summer rally and looking for a year-end upswing, so the timing of this interview is perfect.

The following Q&A really hammers home Acampora's opinion on trying to pick short-term tops in a bull market:

JC – Ralph, this has been so awesome for me and I know when we put it out there, everyone is going to love it. Do you have any words of wisdom that you want to pass on to young up and coming technicians?

Ralph – What would I say to the up and coming technicians? You know, I asked the same question to Richard Russell about 6 or 7 years ago for the MTA. We had a camera and we archived him. I spent a couple of hours with him, and I wanted to keep that for everyone so 20 to 50 years from today everyone could still see the master of Dow Theory. Well at the very end I said to him; "Richard, what is the best advice you could give to the new generation of technicians?" He stared right into the camera and said, "Never fight the primary trend." I smiled and said, "Spoken like a true technician, a true Dow theoretician." My advice is you have to respect trends.

Speaking of not fighting trends, here's a very interesting study Schaeffer's Senior Quantitative Analyst Rocky White and I just completed. Since we've had a strong start to the year, what does that mean for the fourth quarter? At the same time, this is an election year, which needs to be a factor. For a quick refresher, we said in June that when a Democrat is up for re-election, the old adage of "Sell in May" was wrong and a summer rally was likely. Fortunately, that played out, so here's another Presidential-based study.

After crunching the numbers, the best way to sum it up is that strength begets strength.

The bottom line is ... going back to 1900, the higher the Dow Jones Industrial Average (DJI) is up after three quarters, the higher the chances of a big fourth quarter are during Presidential election years. Given the Dow was up 9.98% as of the end of the third quarter this year, this bodes rather well for continued strength into the end of the year, and potential all-time highs along the way. Based on history, when the Dow is up between 5% and 9.99% (like this year), it is higher every single time in the fourth quarter for a stellar 7.58% return. Not bad!

Year-To-Date and Fourth-Quarter Returns for the Dow Jones Industrial Average in Election Years since 1900

We've frequently referenced the power of hedge funds to chase performance into the end of the year, and observed the huge amounts of money still on the sidelines, which could also come in and create a huge bid for the market over the next few months. Adding in the above data to these existing drivers further confirms expectations that a strong year-end rally is very likely.

For fun and historical backdrop, here are all the fourth-quarter results for the Dow, along with the winning President.

Year-To-Date and Fourth-Quarter Returns for Dow Jones Industrial Average With Winners of the Presidential Election
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