"October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February."

--Mark Twain

Even as the U.S. and European stock markets hit 10-month highs in August, many large investors have been betting on a large correction in the autumn. David Einhorn of Greenlight Capital, a multi-billion dollar hedge fund, has invested 25% of his fund into S&P 500 puts, an outsized bet on a drop in the U.S. stock market. And he's not alone. The put/call ratio on the S&P 500 has soared over the past few weeks. September futures on the VIX, a measure of expected volatility based on options on the S&P 500, have also jumped.

How you handle a potential market swoon in the next month or so may make the difference between having a great year in the stock market, or merely a good one.

A Peculiarly Dangerous Month: A Grim History

October has a particularly bad reputation among investors as a bad month for stocks. Yet, Mark Twain's famous quip notwithstanding, September is the month that has cost investors the most money over time.

The Wall Street Journal recently highlighted the U.S. stock market's unsettled history during the month of September. It was a year ago this week on Sept. 3 that Lehman Brothers collapsed, bringing the entire global financial system to its knees. And it was also in September 2000 that the post-dotcom bubble collapse accelerated. Two years later, in September-October 2002, the bear market hit its lows. And although the 1998 financial crisis began in late August, it was in September that super hedge fund Long Term Capital Management collapsed.

But September's weakness stretches back farther into the past. The crash of 1987 may have happened in October, but the market began its descent right around Labor Day. And although the crash of 1929 is commonly associated with October, the market peaked just around this time of the year. The worst month of the Great Depression? That took place in September 1931, when the Dow fell a whopping 30%.

This is also one bit of market lore that stands up to rigorous statistical examination. Since 1926, September is the only month of the year with an overall negative average return in U.S. markets. In every other month, investors have averaged a 1% gain. Equally importantly, the September anomaly holds true not only for the United States. A recent Georgia Tech study looked at data for 18 developed stock markets around the world going back as far as 200 years. Among the markets examined, investors lost money in September in 15 of them.

A Peculiarly Dangerous Month: The Bears Roar

The “glass half empty” crowd can marshal a lot of data to argue that September 2009 is set to live up to its grim reputation. Formerly red hot emerging markets have stumbled, with August marking the sector's first negative month since March. The Chinese market officially entered bear market territory having recorded a 20% drop. The U.S. market rally over the last few months has been on very low volume. And m uch of that volume has been concentrated in just a handful of financial stocks, with o ver 40% of the total volume traded last Friday limited to four issues: AIG, Fannie Mae, Freddie Mac, and Citibank. Finally, perma-bears like David Rosenberg argue that the S&P 500's fair price based on projected GDP growth is 850. That's more than 17% below current levels.

Nor are the economic fundamentals of the global economy any more compelling. Global trade has collapsed with Japanese exports still down 37% from their peak, and shipments to China 15% lower than a year ago. Toyota announced last week that it was planning to shut an assembly line for the first time in its 72-year history. Consumer confidence in the United States has fallen to a four-month low, bad news for a sector that represents 70% of U.S. GDP. And then there is always a possibility of “Black Swan” events like a sudden surge in swine flu that could infect as much as 50% of the U.S. population, and result in up to 90,000 deaths.

A Peculiarly Dangerous Month: Your Strategy?

Why markets do so poorly in September is one of the great mysteries of stock market history. Some even blame seasonal affective disorder. Investors simply get grumpy and sell just as the days get shorter.

Yet for all of its apparent predictability, there's not that much you can, or even should, do. For one thing, no s tock market pattern is writ in stone. The stock market actually jumped in both September of 2006 and 2007. And u nless markets completely fall out of bed, as they did last year, the transaction costs of selling before the end of August and re-entering the market a month later are not worth it.

Here's why I am optimistic about markets once they get over the September hump. The recent rally in global stock markets has not been driven by optimism, but by a reduction of pessimism. The market was priced for Armageddon in March, and now it's priced for recession. This highlights one of the most counterintuitive rules of stock market behavior you'll ever hear: the future doesn't have to look bright for stock markets to do well. The future simply has to look better than the present.

So view the current negativity in global markets as a welcome sign. It lowers expectations. And it's when low expectations are beaten that markets really break out on the upside. After September's bout of nervousness, get ready to pile back into global stock markets for what I expect to be a very strong fourth quarter.

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