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Awful quarter for Wall Street may be only the beginning

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By Ryan Vlastelica

NEW YORK (Reuters) - This past quarter was miserable for bullish U.S. stock investors. The bad news is, things may get worse before they get better.

The S&P 500 <.SPX> fell about 14 percent in the third quarter -- losing about $1.7 trillion in market cap, according to Thomson Reuters Datastream -- as the U.S. economy struggled and a resolution to Europe's sovereign debt woes proved elusive.

The quarter was the S&P's weakest since the fourth quarter of 2008, the peak of the financial crisis. Many analysts say persistent uncertainty overshadows any near-term value created by share price declines.

"I don't see great opportunities and wouldn't encourage aggressiveness until we see some stabilization in Europe, China and here," said Jerry Harris, president of asset management at Sterne Agee in Birmingham, Alabama.

"We may be approaching that point, but it's too early to have a lot of conviction and there's not much potential for prices until we start getting better economic numbers."

According to a recent Reuters poll, the S&P is seen ending 2011 at 1,250, which would represent a gain from current levels but would still be slightly in the red for 2011.

The 1,250 target was lower than the 1,400 target in the previous quarter's poll, a sign of how global headwinds have dented sentiment.

In a sign of how investor fear has spiked, the CBOE Volatility index <.VIX> surged 146 percent in its biggest-ever quarterly percentage move. The concern is that this volatility shock may not dissipate -- a sign investors may be looking at another recession and an extended period of underperformance.

Derivatives strategists at MKM Partners found that in periods in which volatility remained high for several months, stocks underperformed. During similar periods in 2002 and 2010, the S&P 500 was range-bound and choppy and did not set a long-term floor until the VIX dropped below the 25 threshold. It closed on Friday at 42.96, the highest in six weeks.

As protection from downside, many money managers are advocating positions in large-cap, dividend-paying stocks, which are seen as more stable in a volatile market.

Bruce McCain, chief investment strategist at Cleveland, Ohio-based Key Private Bank, said the next quarter would be a stockpicker's market. He cited McKesson Corp <MCK.N>, McDonald's Corp <MCD.N> and Google Inc <GOOG.O> as attractive plays.

"These are names where the fundamentals are strong and they're likely to do well regardless of what the economy does," he said. "Given the potential for significant overseas slowing and therefore weakness in U.S. exports, we think it's better to focus on fundamentals."

UPSIDE IS POSSIBLE BUT RISKS ARE HIGH

The market's sell-off over the past three months could have created some bargains.

Caterpillar Inc <CAT.N> lost about a third of its value in that time while Freeport-McMoRan Copper & Gold Inc <FCX.N> has slumped 41 percent. Netflix Inc <NFLX.O>, an investor favorite that was the S&P's top gainer in 2010, lost 57 percent, one of the worst slides in the S&P this quarter.

"The October earnings reports might provide investors with a better sense of things in 2012 ... stocks may recover some of their lost ground," said Keith Wirtz, chief investment officer at Fifth Third Asset Management, with $18 billion in assets.

"Investors should be positioning for better stock conditions, lowering cash balances and renewing their commitment to commodities."

Bank of America <BAC.N> lost 44 percent while JPMorgan Chase <JPM.N> fell 26 percent in a brutal quarter for banks.

"Financials may have found a bit of a bottom at these levels, so from that standpoint they might find some support going forward," said Michael Matousek, senior trader at U.S. Global Investors Inc, which manages $3 billion in San Antonio.

"We're seeing people start to buy them, but I wouldn't go all-in with that bet. The odds for further declines aren't completely gone."

The underlying problems in Europe remain a tremendous weight. Measures of insurance against default show investors still worried about European banks and those that may be exposed to them. The market's penchant for falling on unsupportive headlines shows institutional investors remain unconvinced of the equity market's direction.

German lawmakers' approval of new powers for the euro zone's crisis fund was seen as progress in confronting the sovereign debt issue. But it has hardly been resolved.

"The vote in Germany was good news, but we also remain at the mercy of politicians here and abroad," said Andrew Goldberg, market strategist at J.P. Morgan Funds in New York.

"That's my biggest concern, and why investors should be cautious over the coming months."

(Additional reporting by Doris Frankel in Chicago and Jennifer Ablan in New York; Editing by Dan Grebler)