The Wall Street Whirlwind

4th-Quarter Forecast: More Turbulence

Boy, that felt bad.

Few investors can remember a more tortuous quarter than the one that just passed. The financial system creaked and rocked and nearly collapsed. The names are notched in our nightmares: Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, Washington Mutual.

So how did the stock market do?

Not as bad as you might think. The Dow Jones industrial average fell 4.6 percent during the third quarter. That was better than the index's 7.44 percent decline in the second quarter. The financial sector -- which stood in the eye of the storm -- even eked out a minuscule gain in the past quarter. The Standard & Poor's 500-stock index and Nasdaq composite had a rougher time: Both ended down 9 percent. Energy companies also slumped, with the sector declining 25 percent.

Expect similar turbulence in the fourth quarter, analysts and economists said. Congress has passed legislation allowing the government to buy up the toxic mortgage debt of financial firms, but it is unclear how quickly it can be implemented and how well it will succeed in thawing the credit freeze. The housing sector needs to stabilize and jobless rates improve before the economy -- and stocks -- have a chance for a recovery, they said.

"We're going to have a crummy fourth quarter but we could see a return to normalcy early next year," said Bill Knapp, investment strategist at MainStay Investments.

The best strategy for investors, analysts said, is to prepare for turbulence and invest for the long term. "Stick to your plan. Make sure the money you have in the equity market you don't need for a while -- hopefully for 10 years, but no less than five years. It's going to be a wild ride for a while," said Doug Roberts, chief investment strategist for New Jersey-based Channel Capital Research.

Review your portfolio, but don't panic, said Charles McMillon, president and chief economist for MBG Information Services, a District-based business forecasting firm. "Don't do anything rash or foolish. Don't expect the stock market to bounce back any time soon," he said.

Market performance in the next quarter could depend on where the economy actually is in its slowdown, analysts said. Have investors already priced in a sharp downturn, or even a recession? Some sectors, such as financials, have already been hit to recessionary levels, but similar declines have yet to emerge in many other sectors, they said.

Market observers are watching to see whether economists begin to project that the economic downturn will be even worse than expected, said Ed Yardeni, chief investment strategist for Yardeni Research. "There has been a lot of use of the word depression. Even policy makers are using that term," he said. "Attempting to sell the rescue plan by saying it's this or the end of our economy -- that doesn't create a great deal of confidence."

The financial sector gained 0.8 percent last quarter, helped by some growing regional banks that have managed to skirt the financial crisis, analysts said. The government's intervention helped shield the rest of the sector from deeper losses, analysts said. While National City fell more than 50 percent during the quarter, Charles Schwabb was up 25 percent. Cardinal Financial, a Virginia community bank, gained 29 percent, and SunTrust gained 27 percent.

"Don't run away from that sector. There is going to be value there. There are going to be survivors," said Knapp of MainStay Investments.

The Bush Administration bailout package could help stabilize the sector more during the next three months, said Bill Stone, chief investment strategist for PNC Wealth Management. "I suspect we will get some relief in the short run, but it's going to take some time for this thing to work its way through the system," he said.

Meanwhile, other sectors, including energy and commodities, are expected to rise or fall along with the economy, analysts said. For example, a decline in housing values that has helped depress consumer spending will continue to affect the retail sector, they said.

A two-month decline in oil prices that helped buoy the market at some points during the quarter dragged down energy stocks. If the economy remains wobbly, oil prices could fall even further, analysts said. Exxon Mobil fell 12 percent during the quarter, and Chevron fell 16 percent.

If the economy remains weak, oil prices could fall even further. That's good news, Stone said. "It's putting money back in people's pockets that they can spend on something else."