The fourth quarter of the year is often associated with a seasonal rally in the stock market, and this year is no exception. According to UBS’s Rebecca Cheong, the S&P 500’s 4M recovery score is currently at 12%, which is far from turning bearish. This means that either 13 consecutive days of rally and collapse or 23 sell-off and stay days are needed to flip bearish.

Cheong projects that the SPX will gain between 4% and 8% in the fourth quarter, driven by several key sources including foreign investors who resumed net purchases in August, short covering with S&P 500 stock short interest at a five-year high, and systematic funds as low volatility persists.

However, Cheong also warns of a sharp drawdown likely by the first quarter of next year. According to her analysis, risk control, CTAs, and long/short funds are approaching or even surpassing peak exposure levels seen in 2018 and 2020, which preceded sharp SPX declines of over 10% in February of those years.

Furthermore, the latest Treasury data shows that US households’ equity holdings as a percentage of financial net assets have reached a new high of 48%. Their equity exposure relative to disposable income is also at a twin peak of 242%. These figures suggest that retail investors may continue to be sellers in the market.

While the fourth quarter rally seasonality is set to continue, investors should be prepared for a potential sharp drawdown in the first quarter of next year due to overexposure by risk management and other funds. It is essential to monitor these trends closely and adjust one’s investment strategy accordingly to minimize losses.