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Stock Rally in Fourth Quarter is Possible with Modestly Positive Corporate Earnings and Progress on Resolving Eurozone Debt Crisis

Earnings estimates for the third quarter have been revised down over the past couple of months as the global slowdown has led to top-down changes. According to ISI Research, the current consensus for S&P 500 companies is now 14.1% earnings growth year-over-year, down from 17.6%. A benefit is that the bar has been lowered. We believe the lower threshold is likely to be at least modestly exceeded as demand in much of the economy has not fallen off a cliff and economic indicators continue to suggest at least sluggish growth. A positive earnings season, combined with some marginal signs of progress on resolving the eurozone debt crisis, could aid a fourth quarter rally in stocks.

Additionally, sentiment indicators suggest a better market. These indicators tend to be contrarian in nature, so when consumers and investors increasingly despair, the outlook for stocks tends to improve. Recently, the Ned Davis Research Crowd Sentiment Poll reached pessimistic levels not seen since the 2008 financial crisis, which preceded a nice short-term rally in the market. Also, Consumer Confidence as reported by the Conference Board remains well below the 66 level that has been an indicator of positive stock market performance in the past. The average gain for the Dow when confidence has been below 66 has been 12.5% annualized. Remember, the stock market is a leading indicator and many economic indicators reflect what’s already happened in the economy (i.e., are lagging indicators).

It is always vital to maintain a diversified portfolio that is appropriate for your time horizon and risk tolerances. If you are under-exposed to equities, we recommend taking advantage of market volatility to add to positions. Valuations are attractive given low interest rates; if a recession is avoided, estimate cuts have probably been sufficient; and the aforementioned sentiment conditions are a positive.

Fed impact in question, while Washington solutions remain doubtful

The Federal Reserve continues to try a wide variety of actions in an attempt to stimulate the economy. The latest iteration has been "Operation Twist" which involves using proceeds from shorter-maturity securities to invest in longer-maturity maturities. Since the announcement, the yield curve has indeed flattened, which was at least partially the goal, but we have yet to see mortgage applications pick up substantially, suggesting the impact may be limited.

The Fed's frustration with Congress was fairly evident in Chairman Bernanke's testimony as he noted that each policymaking arm had a part to play in trying to stimulate economic growth. Confidence among businesses and voters in Washington remains extremely low and businesses continue to point to uncertainty with Washington policies combined with increased regulatory burdens as to reasons why corporate spending remains stymied. While it appears the jobs bill proposed by President Obama has little chance of passage and we question the effectiveness of it even if it should pass, we are now looking toward the November deadline for the recommendations from the debt committee. We remain hopeful that something meaningful and substantial results from their meetings, but given the current environment, aren't holding our breath.

Tide turns on eurozone debt crisis?

There has, however, been some positive movement in Europe and the eurozone debt crisis may have turned in a positive direction, as policymakers’ discussions about a “euro TARP” is a sharp reversal from recent denials that banks need additional capital buffers. The possible turn toward coordination and action by policymakers brought relief for global markets. We remind investors that the most significant moves in stocks often come as trends change direction.

While orderly solutions appear more likely than disorderly chaos and a collapse of the eurozone banking system, or Lehman 2.0, it cannot be dismissed outright. A “euro TARP” still has obstacles, policymakers have disappointed in the past, and a detailed plan is at least several weeks away.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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