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What's in Store for the Markets this Quarter?

As the calendar turned to fall, the markets began to rise. While bonds posted a respectable 2.5% gain for the third quarter, measured by the Barclays Aggregate Bond index, the S&P 500 posted an outstanding 11% gain for the third quarter. This performance was driven by an unusually strong September. The gains during the quarter were far from steady. Volatility was high as the S&P 500 moved up and down-and up again-within a 10% trading range during much of the quarter.  Despite the strong gains in September, the stock market ended the third quarter not far from where it began the year.

Historically, there are some key drivers that may work in our favor and lift stocks beyond their third quarter trading range.  What we are talking about here are the following insights on the potential positives likely to occur this quarter:

- A one and a half (not double) dip for the economy.  Slow, but positive economic growth is likely to support modest stock market gains in the fourth quarter.

- The mid-term elections may result in a return of political balance in Washington.  While political balance between the parties may slow the pace of legislative change, the resulting 'gridlock' has historically been favored by the markets.  In addition, depending on the outcome of the election, it is possible PAYGO (Pay-As-You-Go) rules that require budget offsets to any tax cuts are waived allowing the extension of many, if not all, of the Bush tax cuts into 2011.

- Quantitative Easing (QE), Version 1.5 from the Fed.  At the Federal Reserve meeting on November 3, 2010, the Fed is likely to announce additional stimulus measures to improve economic growth. The coming bond purchases may be half the size of Quantitative Easing, Version 1 (the first round of QE the Fed enacted during 2008 and 2009).

The volatility that has been the key characteristic of this year's stock market performance is likely to continue but should present opportunities for those investors patient enough to ride the market's ups and downs.

Finally, the fourth quarter of mid-term election years is almost always favorable for stocks. In fact, fourth quarter gains as measured by the S&P 500 index typically average 8% in mid-term election years. The only two exceptions since 1950 were 1978 and 1994, when the Fed was hiking rates aggressively, a critical factor that is highly unlikely to take place this quarter. So far, stock market performance in 2010 has tracked the typical pattern for U.S. stocks in mid-term election years, albeit with a bit more than the usual volatility.