4 Scenarios to Spark a Rally

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Buy stocks now and cash out at Christmas.

That may sound like bizarre advice, given the market's wild swings over the past couple months. But if history's any guide, a year-end rally may not be so far-fetched. The U.S. stock market tends to lag in the third quarter before finishing the year on a high note: Since 1945, the Standard & Poor's 500 index has gained an average 7.2% in the fourth quarter, following a drop of 10% in the third quarter. In fact, stocks have risen in the fourth quarter nearly four out of five times during that period, says Sam Stovall, chief investment strategist for Standard & Poor's Equity Research.

A fourth-quarter surge, often referred to as "the Santa Claus effect," couldn't come at a better time for investors. The Dow Jones Industrial Average is down more than 5% this year, and 14% since April. For baby boomers -- many of whose 401(k) balances had just snapped back to pre-2008 crash levels before the recent market slide -- the losses could mean the difference between working another year or two and retiring.

Trying to time such a rally -- if it indeed happens again this year -- won't be easy. Studies have shown over the years that investors typically pick the wrong time to start buying, or dumping, shares. They buy high and sell low. Recent market volatility makes timing decisions particularly difficult, even for the pros. Since the start of August, the Dow has had 15 days with intraday swings of 300 points or more. Last week, the Dow Jones Industrial Average plunged more than 700 points in less than 24 hours after the Federal Reserve announced its latest plan to pump up the economy; this week stocks are once again rallying on hopes Europe can solve its debt problems. "With timing, you'd have to get three things right: when to get out, when to get back in and where to invest that money in the meantime," says Colleen Jaconetti, an investment analyst with Vanguard.

On top of that, history may not repeat itself. In fourth quarter of 2008, the S&P 500 plummeted 22% after the collapse of Lehman Brothers started a market decline that pushed stocks into negative territory for the year, and lasted well into 2009. The stock market crash of 1987, which occurred over several days in October of that year, led to a loss of more than 20% for the fourth quarter and ended a five-year bull market.

So what would it take to get history on our side? Analysts and investing pros admit there are plenty of economic headwinds -- from Europe teetering on the brink of recession to high unemployment and sluggish economic growth at home. "I don't want to sugarcoat it -- most of the evidence is bad," says Larry Puglia, portfolio manager of the Blue Chip Growth funds for T. Rowe Price. "But that can change." Here are four scenarios -- some are serious long shots, other more within reach -- that could help spark an end-of-the-year rally.

Europe solves its problems
Likely? Somewhat

Investors have been fleeing stocks in large part over fears the European debt crisis will drag down the global economy -- and equities along with it. This year through August, domestic equity mutual funds have seen estimated outflows of $70 billion, according to the Investment Company Institute. But equity markets would likely get a boost if European leaders pull together a rescue plan for Greece and other heavily indebted euro-zone countries, says Alexander Godwin, global head of asset allocation for Citi Private Bank. Markets have responded to even minor developments. Markets rallied Tuesday morning on the news that Greece's parliament approved a new property tax law needed to enact austerity measures, but half of those gains were pared back by the end of the day after a report showed that euro-zone leaders are divided on the terms of Greece's second bailout package.

One major roadblock: Some European officials, including the International Monetary Fund, European Commission and European Central Bank, want to see Greece cut government jobs, raise taxes and reduce pay and benefits -- moves which could in the short run make the situation in Greece and Europe worse, says Godwin.

Government action
Likely? Long shot

It's no surprise that investors have become skeptical of the government's ability to boost the economy. The Federal Reserve's move last week to encourage more borrowing and spending by driving down interest rates was met with a massive two-day selloff of stocks. But some investing pros are still holding out hope that some government action could help. For one, if the special deficit reduction supercommittee tasked with reducing the deficit by $1.2 trillion is successful, investors may become confident enough in the economy to once again purchase riskier assets like stocks, says Joseph Tanious, a market strategist for J.P. Morgan Asset Management. Likewise, if Congress rolls out a year-end tax break to reduce or eliminate capital gains taxes, or allows investors to avoid taxes on dividends, says Randy Bateman, chief investment officer of Huntington Funds.

Companies spend their cash
Likely? Within reach

Companies are sitting on a record amount of cash -- those in the Standard & Poor's 500 stock index have a whopping $976 billion in cash and short term investments, estimates Standard & Poor's. If they were to spend some of that cash on expanding their businesses or rewarding shareholders, it could boost stocks, analysts say. An increase in mergers and acquisitions, for example, would likely lead to stock gains as investors load up on shares of smaller companies they believe are good acquisition targets, says Bateman. But the chances of M&A activity picking up are dwindling as all the market uncertainty has made companies reluctant to acquire, says Martyn Curragh, the leader of U.S. transaction services for PricewaterhouseCoopers.

A more likely scenario, says Godwin: Companies start using their cash hoards to buy back shares or increase their dividend payouts. Such moves could also kick-start a rally, he says. Consider: Berkshire Hathaway's announcement on Tuesday to buy back what could amount to tens of billions of dollars' worth of the company's shares was followed by a 272-point gain in the Dow Jones Industrial Average.

Strong corporate earnings
Likely? Within reach

With investor sentiment already at record lows, any piece of good economic news could have an outsized effect on stocks. One possible spark could be corporate earnings, which are expected to increase by 15% from last year. While that's less than the 19% seen in the second quarter, Puglia says simply meeting those estimates would provide enough of a surprise to lift stocks. If companies were to follow those strong reports with a positive outlook for their businesses in the fourth quarter, it could erase investors' fears of a double-dip recession, says Stovall. Another potential booster: Most investors wait until the end of the third quarter to rebalance their portfolios for the coming year. Many investors who pulled back on stocks in August may wade back in to take advantage of cheaper shares.

However, if consumer spending sinks lower and unemployment remains high, experts say companies could have a tough time increasing their profits. "Without some improvement in the economy and job creation, it will be difficult for companies across the board to maintain the robust pace of earnings we've seen," says Puglia.