Why the Fourth Quarter Won't Be Any Better For Stocks

In yesterday's essay I explained why I think the Fourth Quarter will offer plenty of more surprises-to the downside-for unsuspecting investors. My reasoning for this is simple: analyst estimates for the 4Q08 are still far too positive (the fact that they're positive at all says a lot about the quality of analysis).
However, there's another component to the ugliness that will be 4Q08: performance gaming.
If you're unfamiliar with the term, it describes a process in which fund managers and other institutional investors close out losing positions to mask their performance for the Quarter. By doing this, the manager avoids reporting his losing positions thereby "gaming" his performance.
I'll explain.
The SEC requires fund managers to publish their existing positions at the end of each quarter. According to SEC regulation, they have to publish the names of the companies they own, as well as the number of shares they own and the value (in dollars) of their position.
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Because of this, it's fairly easy to gauge the profit or loss they've posted on any position that's been in the portfolio for more than a quarter. However, it's important to note that managers only have to post the positions they own at the end of the quarter... not the day before that... or any other day during the quarter for that matter.
So, if a given position is deep underwater, a fund manager can liquidate it and simply report a larger cash balance at the end of the quarter, thereby temporarily covering up the loss. Of course, this technique doesn't work in the long-term-all of the fund's moves can be pieced together via other SEC filings-but at that point bonuses have usually already been handed out, so who cares?
Now, on to 4Q08.
By any measure, October has been one of the worst months in financial history. Stocks posted their worst single day drop since the Crash of 1987. They also posted their worst week EVER. And if the year had ended on October 10, it would have been one of the worst years for US stocks in history. Despite a few up days, the S&P 500 is still down 38% as of yesterday's close.
Now, it's widely documented that most funds trail the stock market in terms of returns. So what are the odds that most, if not all, institutional investors are currently underwater on a sizable portion of their portfolios? And which is going to look better at the end of the fourth quarter: a portfolio full of losses or fewer losses and more cash?
The liquidations we've seen thus far from institutions have largely stemmed from redemptions-clients pulling their money from the fund, forcing the fund to liquidate its holdings to return the money. Between this-it's not like fund clients are suddenly going to become confident about the market again-and the wave of liquidations from performance gaming, the market is going to experience plenty of downward pressure come the end of 4Q08.
The only thing that could amend this would be a substantial rally. So if stocks don't break out of their trading range during the next six weeks, I'd be very wary about mid- to late-December.