3rd quarter: Whew, it's finally over

NEW YORK (CNNMoney.com) -- The last three months on Wall Street have left the broad stock market up nearly 2 percent.

That's not a bad gain - until you consider the path it took to get there.

For many people, the third quarter was roughly the equivalent of trying to run from the house to the storm shelter in the middle of a tornado. And just when the shelter's food stock was running low, Ben Bernanke and the Fed gang delivered a supply of canned goods.

"When you consider the amount of damage that was done to the bond market in the quarter and the critical issues in the financial market, the fact that the market has ended up higher is impressive," said Ned Riley, chief investment strategist at Riley Asset Management.

The crisis in financial markets this summer - sparked by the combination of a meltdown in the housing, mortgage and the credit markets - caused stocks to plunge more than 10 percent off the year's high points reached in late July. That 10 percent move is the technical definition of a stock market correction and, in terms of the Dow, meant a drop of close to 1,500 points in a span of less than 30 days.

A lot of that happened in the first month of the quarter, between the time the Dow hit an all-time closing high of 14,000.41 on July 19 and the last trading day of that month. But it didn't stop there, with the plunge continuing through Aug. 16, when the Dow hit 12,517.94 during the session.

But the market didn't drop and roll - it dropped and bounced. Between the lows of Aug. 16 and yesterday's close, the Dow bounced back nearly 1,400 points. Are you dizzy yet?

Two main events caused the bounce back: technical factors and the Federal Reserve.

Looking at the S&P 500, a much broader index than the Dow, it slumped 11.7 percent between its July 19 high and the Aug. 16 low, hitting that correction point. Since then and yesterday's close, it's climbed back 11.7 percent, with the "correction" clearly having been used as a point of re-entry for traders and other market professionals who were waiting for the 4-1/2 year old bull market rally to retreat a bit before they jumped back in.

But it's no coincidence that the day after the S&P 500 hit that correction point, the Federal Reserve announced that it had cut the discount rate, a largely symbolic bank-lending rate, by a half-percentage point. Not only did the move help reassure banks, but it sent a psychological message to investors that the Fed was concerned and was going to help.

Many Wall Streeters also took the move as a hint that the Fed would cut the more closely-watched federal funds rate, which affects consumer loans, at the Sept. 18 Fed meeting. And they did cut rates that day, for the first time in four years - by a half-percentage point. It was a bigger cut than what most people were expecting, even after the sobering August jobs report. In the statement, the bankers acknowledged the threat to the economy that the financial market crisis was causing.

The biggest theme of the third quarter for stock investors has been the "fear of the unknown about the housing and the mortgage market," said Jeff Layman, director of investment services at BKD Wealth Advisors.

"The fact that the Fed stepped in and gave people more than what they were expecting has helped," he said. "It's made it clear that the Fed is now more focused on economic growth versus expectations for inflation, at least for the time being."

Raise your hand if you're surprised that the worst-performing stock in the S&P 500 in the third quarter was Countrywide Financial (Charts, Fortune 500). Anyone? The poster child for the subprime mortgage mess slumped 48.1 percent as of Thursday's close and was one of many mortgage and financial market stocks that had a hell of a time over the last three months. (See chart for details.)

Year-to-date, the homebuilder stocks have still had it worse. Pulte Homes (Charts, Fortune 500) was the only builder that made it into the bottom 10 S&P 500 stocks this quarter, but the bottom 10 in 2007 also includes homebuilders Lennar (Charts, Fortune 500), KB Home (Charts, Fortune 500), Centex (Charts, Fortune 500) and D.R. Horton (Charts, Fortune 500).

Retailers have had a hard quarter, too.

On the upside, record-high oil prices have been good for the drillers and other oil services firms. And the weak dollar has helped some big, multi-national blue chip companies in the last few weeks. Meanwhile a number of tech stocks have benefited - particularly in the last month - from expectations that their third-quarter earnings won't be too bad, since they have little or no subprime exposure.

How the fourth-quarter plays out could be determined by the third-quarter earnings reports. A few have already been released, including a spate of mixed reports from the financial sector over the last week. But the reporting period really starts to heat up the second week of October. How the earnings are impacted, both negatively and positively, will likely be a big factor in near-term stock market direction.

That, and of course, the economy.