Betting on the next move: What's next for stocks?

A big rally gave the S&P 500 its best 3rd quarter in 9 years and pushed the Dow near record highs. Can investors keep it going?

What happened? The stock market was supposed to be all bad in the third quarter.

Terribly bad for the bulls. Wonderfully bad for the bears...

The quarter's was anything but bad for Wall Street. The S&P 500 is on track for a gain of 5.2%, which slowing a bit today, is the best third quarter in nine years for the broad index.

The third quarter is usually the worst of the year. And this year it was supposed to be especially bad since 2006 is a mid-term election year, and third quarters in those years tend to be the worst of the worst. Yet 2006 showed to be the best third-quarter in a mid-term election year since 1982, when the market rallied after hitting a bear market bottom in August, according to the Stock Trader's Almanac.
The rally has put the S&P 500 at another 5-1/2-year high and pushed the Dow near its record close set in January 2000, at the end of the 1990s boom. How did all this happen? And what's next for the market?

"A good third quarter in any year is unusual and one in a mid-term election year is even more unusual," said Jeffrey Hirsch, editor of Stock Trader's Almanac. "But there's no historical record of what it means for the fourth quarter."

That's a period that typically starts out weak on Wall Street but often ends up with a year-end "Santa Claus" rally. But will the showing so far this year, do the bulls need a rest?
The market got a boost this week from classic end-of-quarter moves by money managers who wanted to buy up winners before closing their books on the quarter.
When the quarter ends or even after the mid-term elections and all the heavy buying ends, we could still see a pullback. We can note the tendency for stocks to slip in early October, but then rally through the end of the year.

There are many reasons the market has been doing well. The economy's still growing, although more slowly than in recent quarters, and corporate profits remain robust. The economy and earnings have held up even after a two-year rate hiking campaign from the Federal Reserve, which is now apparently on hold. Then there's the steep decline in oil and gas prices that have taken the edge off inflation worries and put more money into the hands of consumers.

On the other side of the ledger, the bull market, at nearly four years old, is ancient compared to other bull runs. Plus the economy is slowing, sharply, though it is still growing. Plus the housing market is eroding.
Yet, stocks are doing well. Year-to-date, the S&P 500 is up 7.3%, the Dow is up 9.4% and the Nasdaq composite is up 2.6%. The strength has surprised investors and even some seasoned market professionals.

Like other market historians, Standard & Poor's chief strategist Sam Stovall thought the third quarter would be a weak one. "My feeling was, here we are in a mid-term election year and we haven't had a 10-plus percent bull market correction," he said.
Both Stovall and Hirsch said the second-quarter decline of 7.7% on the S&P 500 could have been the sell-off for this year, although it would be light compared to other mid-term election year dips.

Now what?

Just like in May, the Dow is currently nearing its record closing high and the S&P 500 is at a 5-1/2 year peak. Still, the Nasdaq remains buried 55% off its high hit in March 2000, when the Internet bubble peaked.
From such lofty heights, could stocks be primed to slump through the rest of the year?

That doesn't seem likely, most analysts said, but there are risks.

Investors seem to be back in a "Goldilocks" market, betting that growth is not too hot, not too cold, but just right. The economy is slowing, but not too much, and commodity prices are coming in, which means more money in consumer pockets going back to retail.

A slower economy would hurt corporate profits, drive up price-to-earnings ratios, which would then make stocks seem less attractively valued. In fact, earnings disappointments are probably the biggest threat as investors move into October and third-quarter reports start rolling in.

The concern is, that profit forecasts are too optimistic if the economy is going to slow to about a 2% growth rate next year from an expected 3.5% in 2006.
On Thursday, second-quarter gross domestic product growth was revised down to a slower-than-expected 2.6% rate. And on Wednesday, a monthly read showed a surprise slip in August durable goods orders.

But the market barely noticed either report, a sign investors are not yet factoring in the impact of a slowing economy on stocks.