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. Last Updated: 07/27/2016

Extreme Volatility Has Investors Waiting to Exhale

NEW YORK -- Investors have been holding their breath for more than 2-1/2 years. Now they're waiting to exhale in the final months of the year and early 2003 -- the traditional time for stocks to rebound.

But the optimism may be a case of Wall Street putting bright red lipstick on a pig.

"Way too many players are placing extreme faith in the seasonal bullish aspects of November to April," says Alan Newman, editor of the Crosscurrents newsletter.

"Although we are confident a rally will soon unfold, our scenario calls for an end of the good times by December, with another smash possible in January," he says.

Newman, a long-time bear, believes the Dow Jones industrial average could revisit 6,437, its level in December 1996 when Federal Reserve Chairman Alan Greenspan warned that the raging bull market was foaming at the mouth during his famous speech about "irrational exuberance," driving stock prices higher.

The Fed chief also correctly predicted at the time that speculative bubbles always burst, underscoring the threat that a stock market collapse could be the source of economic instability.

Indeed, stock investors are discovering they're not as well off as they were in March 2000 when the bear market rout started.

People have again been reminded in the last quarter that stock salesmen, who preach about the need to be fully invested in the stock market because the "next great buying opportunity" is just around the corner, were wrong -- in a spectacular way.

An estimated $1.75 billion of market wealth went up in smoke in the 2002 third quarter alone, raising the total lost so far to more than $7 trillion since early 2000.

The third quarter was the second worst for stock mutual funds since the 1987 crash, with funds losing an average 17.5 percent, according to Lipper Inc., a fund tracking firm. Less than 1 percent of the 8,400 funds Lipper monitors chalked up a gain. Morningstar Inc., another fund data firm, says only 86 of the 8,000 U.S. stock mutual funds it tracks posted positive returns and most of the gainers were invested in sectors that do well in bear markets.

The sharp third-quarter loss and a double-digit drop in the second quarter have wiped out investor confidence that began to build in the fourth quarter of 2001 and the first quarter of 2002 when the market's slide showed signs of leveling off.

The Dow average, the Standard & Poor's 500 index and the Nasdaq composite index are now at the lowest levels they've seen since 1996 or 1997. They're on course to post their third consecutive year of double-digit losses.

The market is at the phase of the seasonal cycle when stocks have traditionally done better as investors fine-tune their portfolios in the final quarter and are eager to position themselves for the New Year. Stocks also tend to benefit from the end of the tax-loss selling at the end of October.

In 58 of the last 82 years, the Dow has had positive returns 71 percent of the time in the fourth quarter versus a gain 59 percent of the time in the other three quarters. But this may not be your father's bear market.

The corporate earnings outlook is murky and getting murkier by the minute. Profits of the 500 companies in the S&P index are expected to grow by only 6.5 percent in the third quarter versus a year earlier.

Analysts have been scaling back their estimates steadily. A month ago, they were forecasting an increase of 8.4 percent. At the quarter's start, they expected a gain of 16 percent.

The ultra-optimistic analysts, who have been operating for the past year under the philosophy that the earnings slump was just a speed bump, are still forecasting a whopping gain of nearly 20 percent for the fourth quarter.

It's fair to say the constant downward adjustments in earnings expectations by the "pros" may have created a climate of fear among investors.

"Analysts have been cutting their third-quarter estimates ever since the end of the second quarter," says Ed Yardeni, chief market strategist for Prudential Financial.

Then there's the nail-biting about the effect on investors' psychology from a possible war with Iraq and the impact of soaring oil prices on the global economy.

"I doubt that stock prices can rally significantly until the Iraq issue is resolved," says Yardeni. "In the meantime, stocks could continue to fall."

The market's technical picture is ugly, he says. The S&P 500 has crashed by 40 percent this year and stands about 49 percent below its high in March 2000.

It's the biggest slaughter of stock market wealth since 1929. All of the major indexes have punched through some pretty bearish levels, which under normal conditions, should have flashed "buy" signals. Historically, the market has fallen through important technical levels that have set the stage for a sustainable recovery.

Not this time.

"The bad news is we can't be sure the worst is behind us," Newman says. "Volatility is the name of the game. Huge price swings are sure to deter investors, not entice them back."

For the week, the Dow Jones average jumped 4.3 percent to close at 7,850 -- marking the end of a six-week losing streak. The tech-laden Nasdaq index surged 6.2 percent to end the week at 1,210, while the Standard & Poor's 500 advanced 4.3 percent to finish at 835.