Will the Market Save Its Best for Last?

Anthony M. Mazur Jr. signals a trade at the Chicago Mercantile Exchange earlier this month. Traditionally the fourth quarter is a time for stocks to advance. (By M. Spencer Green -- Associated Press)

If the fourth quarter is here, it must be time for a stock market rally.

Such thoughts have stirred in my head lately, and maybe in the minds of other investors, too. You really can't blame us. In recent years, the final quarter of the year has been the best when it comes to owning stocks or stock mutual funds.

In six of the past 10 years, the Standard & Poor's 500 Index has saved its best showing for the last quarter. Over that span it endured only one losing fourth quarter, in 2000, when it fell 8.1 percent.

If we take a simple average of the quarterly percent changes posted by the index from 1996 through 2005, the fourth quarter towers over the other three. By my quick calculation, the fourth quarter averaged a 7.8 percent gain, compared with a 3.7 percent advance in the second quarter, a 1 percent rise in the first quarter and a 3.9 percent loss in the third quarter.

As long as you stayed in the market and didn't jump in or out at the wrong time, the fourth quarter alone was often enough to make your year. With compounding, the S&P 500 climbed through those October-December periods at an average annual rate of 35 percent.

Why this skewed pattern? All sorts of elaborate explanations offer themselves.

It may result from mutual funds reinvesting money raised by weeding out their losers as they prepare their portfolios for year's end. It may also be the handiwork of calendar-conscious traders trying to benefit from the famous January effect, a long-studied tendency for stocks to rise at the start of a new year.

Or it may have something to do with the November elections. In some recent presidential and congressional election years, great angst has surrounded the counting of the ballots. Once the outcome is known and it becomes clear that the republic is still functioning, relief rallies often occur.

While the presidency is not at stake this November, nevertheless there is much uncertainty over whether the Republicans will keep their majority in Congress, or whether the Democrats might gain control of the Senate, the House or both.

Should Congress end up divided, expect to hear echoes of that popular 1990s Wall Street saying: "Gridlock is good!" This maxim holds that a standoff in Washington helps minimize the chances of any troublesome legislative surprises. This fall's vote may present a fresh opportunity to challenge the validity of this theory.

Where stocks are concerned, it's "a myth," say researchers Robert Johnson, Scott Beyer and Gerald Jensen, writing in the Financial Analysts Journal. "Political harmony, when the same party controls Congress and the White House, is more favorable to equities as returns are both higher and less volatile during these periods."

But gridlock does appear to help bond returns, they acknowledge: "This finding supports the view that gridlock leads to a slowdown in legislative action, which in turn dampens government spending, inflation and deficits."

For anyone hoping to hop on stocks' fourth-quarter gravy train, another question must be addressed. Just as the January effect has shown signs of shifting to December or even November, is it possible the fourth-quarter rally is migrating back to the third? As soon as any pattern like the Fourth Quarter Cornucopia comes to be recognized in the markets, investors may start negating it by acting on it ahead of time.

In 2005, the S&P 500 posted a better gain in the third quarter, 3.1 percent, than its fourth-quarter advance of 1.6 percent. This year, the index rose 5.2 percent in the third quarter, not including dividends, for its best July-September showing since 1997.

Patient, long-term investors have the luxury of viewing all this with detachment. The buy-and-holder doesn't care so much when the stock market rises, as long as it finds a way to keep doing that at one time or another.

So if the fourth-quarter bonanza is fading, well then, long live the third-quarter effect.