Market Extra: U.S. stocks: Here’s what to expect over the next three months

NEW YORK (MarketWatch) — The final leg of 2014 is upon us. And as the month comes to a close and the fourth quarter looms, investors are trying to decide how to adjust their portfolios for the final stretch of what’s been a choppy period for investors chock-filled with uncertainty.

September was particularly rocky for investors with the S&P 500 recording a 1.6% decline over in the month but still boasting a 6.7% gain year-to-date.

How the rest of the year turns out will largely depend on whether investors remain skittish or turn more optimistic about future stock returns. Conflict in the Middle East and Russia certainly aren’t making it any easier for investors to be sanguine.

Here are the key themes investors are wrestling with as they consider the outlook for the next three months:

Macro: Investors don’t expect the Federal Reserve to change course. For the first time in a long time, rising rates in the year ahead appear to be a certainty. Stock markets are pricing in the first rate hike to arrive sometime in June 2015. The Fed, however, is data dependent, so investors will be watching economic reports closely. Should the Fed surprise, markets could experience taper tantrum part deux.

There‘s a host of economic data that will need to be digested as well, including this Fridays jobs report, while the GDP report is due October 30. Also worth noting is the Fed ‘s next meeting on Oct 28-29. Slowing China growth and a deflationary European economy also are squarely on investors minds.

Volatility – Implied volatility on the S&P 500 as measured by the CBOE’s Volatility Index, or VIX VIX, +2.07%  , has been trending higher over the past three months and gained 34% in September, bouncing off of very low levels. Most analyst are predicting higher volatility in the weeks and months to come.

Russ Koesterich, BlackRock’s global chief investment strategist, however, strikes a conciliatory tone on rising volatility, pointing out that the VIX is still below historical averages and “as investors begin to prepare for a first rate hike, Wall Street’s fear gauge should continue to normalize.”

Geopolitics – The markets demonstrated amazing resilience. There have been enough geopolitical risks to trigger a 10% correction. Developments surrounding the Islamic State, the Russia/Ukraine conflict, and most recently, unrest in Hong Kong, are being closely watched but have not led to panicky trading.

Divergence: It’s the buzzword of the month. So-called ‘divergence’ refers to underperformance of small stocks versus large-caps, sector rotations and rising credit spreads. The latter – the difference between yields of junk bonds and Treasurys is often associated with the beginning of bear markets. Combined with recent highs on the S&P 500, skittishness around divergence may keep investors on cautious footing. Strategists at RBC Capital Markets in a note to clients stressed that the divergence can not be ignored, adding that unless the markets’ ascent in the fourth quarter is accompanied with a rise in small-caps and cyclical stock prices, it would raise concerns about the sustainability of growth in 2015.

Dollar: The strengthening dollar took center stage in September. The greenback hit multi-year highs against euro EURUSD, -0.01%  and yen USDJPY, +0.03% while the dollar index DXY, +0.34%  hit a four-year high. The consensus opinion is that the growing potency of the greenback has more to do with the slowing foreign economies rather than improvements in the U.S.

So far, it appears the rising dollar is unlikely to hurt profits of large companies, but may help U.S. consumers who would benefit from low oil and gas prices. Dollar strength is also weighing down commodities prices.

Earnings – Companies will begin reporting third-quarter results in a few weeks, with Alcoa unofficially kicking off the season next week. Current expectations are for revenue growth of 3.5% and earnings of 7%, according to FactSet. The S&P 500 forward price to earnings ratios are at around 16.6 and below historical averages.

“The economy is strong enough to function on its own and earnings are poised to go higher. With interest rates staying low well into 2015 and valuations at reasonable levels, we see stock prices to go higher,” Karyn Cavanaugh, enior market strategist at Voya Investment Management, added.

Ultimately, how the markets play themselves out over the next three months is anyone’s guess. But nearly all strategists agree that the road to the end of the year will be bumpy. – Top Stories

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