Signals to Watch in a Pivotal Third Quarter

The economy's many uncertainties make this quarter the year's most important one.
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The third quarter that began this week will be the pivotal quarter of 2003 for stocks.

If consumer spending holds steady and corporate spending on capital goods picks up so that third-quarter economic growth at least matches the 3.5% consensus projection, then stocks are likely to continue the rally through the rest of 2003.

Oh, there will be backing-and-filling like we saw in the days before the

Federal Reserve's

interest rate cut, but the major stock market indices will finish the year substantially above the June highs of 1690 on the

Nasdaq Composite

and 9320 on the

Dow Jones Industrial Average

. Investors who are already up 22% on the Nasdaq or 8% on the Dow for the year would pile up further gains.

But if disappointing guidance for sales and earnings growth in the third quarter and for the rest of 2003 is just the start of disappointing news, stocks are likely to pull back big. Giving back one-third of recent gains would be the best that investors could expect -- and that's only if the fourth quarter redeems a third-quarter disappointment.

Let's take a look at where stocks and the markets are now, and what to look for in the pivotal quarter ahead.

Markets Look Ahead, Not Back

The rally from the lows of March 11 thrust the third quarter into this pivotal role.

For the quarter, the Nasdaq climbed 21%, the

S&P 500

gained 15%, and the Dow rose 12%. (For the period, Jubak's Picks gained 20% after trading costs. For a complete performance report, see the update to this column.)

I've repeatedly called these gains the result of a rally on hope. Certainly there was nothing in the first-quarter economic numbers to start a market rally: The final revision for the U.S. gross domestic product showed a paltry 1.4% growth and a huge decline in corporate spending on capital equipment.

The drop works out to an annualized rate of decline of about 5%. The longer trend showed a 14% decline since the end of 2000. That's bad news for an economy that needs corporate spending to expand if it's going to show sustained growth above 3%.

But the market, as is its wont, decided to look forward rather than backward. Here's why:

The Fed had cut short-term interest rates to 1.25%, with another cut at the end of the period to 1%.

The central bank was increasing liquidity by adding dollars to the economy at an annual rate of better than 10%.

The Bush administration had pledged a tax cut. All that stimulus -- plus the end of the big-unit war in Iraq -- was enough to convince some investors that a second-half recovery was more likely than not.

And once the rally started, it fed on itself as upward moves produced shifts in sentiment that led to further moves that brought yet other investors on board. Huge short positions in many of the biggest technology and financial stocks fueled the rally as short-sellers decided to cut their losses. Advisers and Wall Street strategists who had been hugely underweight stocks added to their positions as the rally stretched beyond a second week. Money managers who had been out of stocks rushed back in toward the quarter's end trying to catch up with the indices.

Will the Immediate Past Be Prelude?

Which brings us to the start of the third quarter. The monetary and fiscal stimuli that led investors to believe in a second-half rally are still in place. But something may be played out: the huge shifts in sentiment that fueled the second quarter's big move.

Sentiment in the latest poll by the American Association of Individual Investors was 71.4% bullish and only 8.6% bearish. Three weeks ago, only 52% of these investors were bullish and 19% were bearish.

The

Investors Intelligence

survey of advisers shows a similarly overwhelming bullish consensus: As of June 25, 59% were bullish and just 18% were bearish.

The Chicago Board Options Exchange's Market Volatility Index, which had been stuck signaling an extremely low degree of investor fear in a range between 22 and 24 for much of June, finished the last full week of June at 21.71. It's safe to say that options pricing indicates that investors feel very little fear of a market drop just now.

And that means the third quarter begins with a very high degree of risk -- as well as with basic economic uncertainty. Just as the high degree of fear, short-selling and bearish sentiment helped fuel the second-quarter rally on the way up, the high levels of complacency and bullish sentiment provide potential fuel to any third-quarter downturn.

So what do you watch for as this pivotal quarter unfolds?

On the economic front, macroeconomic statistics will help set a general psychological tone, but corporate projections for the third quarter will far outweigh the significance of those lagging numbers. And technical indicators will show how the market is solving its sentiment problem.

Keep an eye on these numbers:

Initial claims for unemployment

: Anything that suggests unemployment, a lagging indicator in any recovery, has stopped rising will be a huge plus. Watch to see if the initial claims number can inch its way back toward 400,000 per week, the consensus for break-even on job creation/destruction in the economy. Next data: July 3.

Consumer sentiment/consumer confidence

: These must hold up for the economy to stand any chance at a 3.5% recovery in the third quarter. Consumer spending has been holding the fort while corporations have cut back. The troops can't begin to desert before the CEOs join the battle. Next data: July 18.

Corporate guidance gets off to a slow start this quarter thanks to the July 4 weekend. Only

Yahoo!

(YHOO)

and

General Electric

(GE) - Get Report

are among bellwether stocks scheduled to report next week. But by the week of July 14, earnings reports, conference calls and guidance will be in full swing.

In general, it will be a bad sign if companies shy away from offering guidance for the second half of the year. Guidance from technology companies is especially crucial, because these stocks ran up so much in the second-quarter rally on hopes for the second half.

Five Bellwether Stocks

Bank of America

(BAC) - Get Report

: Look to see what the company says about demand for business loans. Report date: July 14.

Intel

(INTC) - Get Report

: Will personal computer demand pick up at all in the second half? Sales should pick up since the second half, and especially the fourth quarter, is traditionally the strongest period for tech sales. Report date: July 15.

IBM

(IBM) - Get Report

: IBM's corporate business, hardware and software would be among the first beneficiaries of any pickup in corporate spending on information technology (IT). Report date: July 16.

Continental Airlines

(CAL) - Get Report

and

Delta Air Lines

(DAL) - Get Report

: The airlines are good indicators of consumer and business spending. Look for increases in the average selling price of a ticket; that's a sign business travel is picking up. Report date: July 17.

Nokia

(NOK) - Get Report

: The cell-phone giant's earnings report and guidance will give investors a window into so many parts of the global economy. Is Chinese spending on consumer goods and infrastructure recovering after SARS? Is anybody in the wireless industry spending to expand their networks? Report date: July 17.

Two Key Indicators to Watch

Volume on down days vs. volume on up days.

Volume has been relatively light recently on days when the market has sold off. That's exactly what any investor who believes stocks are moving higher wants to see. It indicates that most investors don't feel a need to join in the selling on dips like these. Meanwhile, the rising daily volume as the market continued to rally was another positive sign. It indicated that climbing stock prices were drawing more investors from the sidelines into the market even as the market climbed. That's crucial for a continued market advance.

Short interest.

The absolute number of shares sold short has continued to rise during the rally, but the short interest ratio has fallen. That latter measure is important, because the ratio compares the number of shares sold short with total trading volume. So a decline in the ratio indicates that short-selling has declined as a percentage of total market activity as volume picked up during the rally. An increase in the short-sale ratio caused by seesaw volatility would be good news for those hoping for a higher market in the quarter.

One last bit of advice as you watch all these indicators and signs:

The high levels of bullish sentiment increase the risk in this market. They don't guarantee that the market will take a meaningful tumble. Indicators that are sending warning signs can move still lower and continue to send warning signs for weeks or months.

But the extreme levels of bullish sentiment do guarantee that any downward move in this market has plenty of complacency to feed on, the reverse of the situation that helped drive stocks upward in the second quarter.

To me, that means this isn't the time to be taking on extra risk or hoping to make a killing. In Jubak's Picks, I'm going to continue the conservative bent that worked reasonably well in the second quarter.

Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EDT. At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.