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Craig Allen: With Stock Market Gasping for Air, Where Do We Go From Here?

Stocks close worst quarter since the depths of the recession, but if history is any guide there may be hope for improvement

The stock market experienced one of the worst and most volatile quarters ever in the third quarter of 2011, losing 14.33 percent. It was the worst in performance for the S&P 500 since the depths of the recession, following the Lehman Brothers failure in late 2008. In that quarter (fourth quarter of 2008), the S&P 500 lost 22.56 percent, which was the worst since the fourth quarter of 1987, after the massive market crash in October of that year, when the index plummeted 23.23 percent. The real question is: Where do we go from here?

Historically, when stocks have experienced significant downdrafts in a given quarter, they have tended to rebound fairly dramatically over the following 12 months. After the fourth quarter of 1987, the S&P 500 gained 12.4 percent over the next 12 months. Following a 14.52 percent dip in the third quarter of 1990, stocks gained 26.73 percent over the next four quarters. After a 17.63 percent fall in September 2002, the S&P 500 gained 22.16 percent over the next four quarters, and after the December 2008 quarter, stocks rebounded by 23.45 percent over the next year.

Unfortunately this is not always the case. After a 14.98 percent decline in the September quarter of 2001, stocks actually lost 21.68 percent over the following year. However, out of the 10 quarters since December 1987 that the S&P 500 has lost at least 10 percent (not counting the current quarter), stocks have been up seven times or 70 percent of the time, one year later. More impressive is the fact that, on average, stocks have been up 26.51 percent in the coming 12 months, after suffering at least a 10 percent decline during a quarter.

The best performing period was the 12 months after the March 2009 quarter, when we saw the S&P 500 drop to an intraday low of 666 before gaining 46.57 percent in the next year. The three times when stocks were down over the following year after a 10 percent-plus quarterly performance (-1.12 percent, -21.68 percent and -1.55 percent), averaged only an 8.12 percent decline. (The 21.68 percent decline followed the 9/11 terrorist attacks that contributed to a 14.98 percent drop in the third quarter of 2001.)

If history is any guide, it would appear that we have at least a reasonable chance of seeing positive performance from stocks over the coming 12 months. The problem with using historical precedents to predict future events is that history never quite repeats itself. There are always key differences that influence the performance of the economy and of assets, including, of course, stocks.

There is some cause for optimism, however, in that we appear to have weathered the summer months relatively unscathed from an economic standpoint. The latest reading on employment showed an increase of 103,000 new jobs created in September, which was above economists’ expectations. The previous two months were also revised higher, resulting in an average for jobs growth of 96,000 per month over the three-month period. Sadly, we need to generate upward of 300,000 new jobs each month to make a meaningful impact on the 9.1 percent unemployment rate.

The Commerce Department also revised second-quarter GDP growth up, to 1.3 percent annualized growth from 1 percent. This is also a big improvement from the first quarter reading of just 0.4 percent annualized growth. Economists are forecasting a 2 percent annualized rate of GDP growth for the third quarter, and 2.1 percent for the fourth. If correct on both, we would end 2011 with about 1.45 percent growth for the entire year.

I have been expecting 1 percent to 1.5 percent growth for 2011 and 1.5 percent to 2 percent growth for 2012 since early last year. While this would certainly not be considered robust growth, it is not a double-dip recession either. At this point, I feel that avoiding more serious problems (like another recession) is far more important that achieving strong growth, either in GDP, stock performance or employment. The damage that a second recession would do to the economy, financial markets, employment, and consumer and investor sentiment would be shattering.

If we can end 2011 without seeing another quarter of negative GP growth (it takes two quarters in a row of negative GDP growth to officially be a recession), I feel we will strengthen consumer and investor confidence significantly. This should set us up for stronger economic and financial market performance going into 2012, and, hopefully, will put us on a course to achieve substantial stock market performance over the next 12 months. This is my hope and expectation, and I have positioned my clients’ portfolios to reflect this.

While the threat of a double-dip recession is certainly real, and the problems in Europe, which threaten our economy as well, are far from solved, I am optimistic that a plan can be formulated that will address the worst of these risks. Only time will tell, but in the financial markets, those who wait for that time to pass to see how things will turn out will avoid risk, but will also miss any potential opportunities.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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