Investors can expect a choppy third quarter in the U.S. stock market because of uncertainties over Iraq and the U.S. presidential election, mutual fund research company Lipper Inc. (search) said Thursday.

In general, stock investors seem to like news that is favorable to President Bush and respond negatively to news that is favorable to Democratic presidential candidate John Kerry, Lipper analyst Don Cassidy said.

Market analysts and the media are impatient, and investors are very edgy, Cassidy said in a conference call to discuss second-quarter performance of mutual funds and the outlook for the second-half of the year.

Lipper said it continues to suggest caution and defensive portfolios positioned in consumer staples and health care, as well as energy and utility sectors. Interest-rate sensitive sectors could be underweighted.

"While a difficult environment for stocks may be expected in the next few months, a rally later in the year seems plausible after the fall elections," said Lipper analyst Michael Porter.

At the end of June, the benchmark Standard & Poor's 500 Index (search) and the technology-laced Nasdaq Composite Index (search) were up more than 2 percent for the year, but both have since declined. The S&P 500 is down about 2.2 percent and the Nasdaq about 4.7 percent since June 30.

A sign of investor unease can be seen in the decline of equity purchases in recent months after inflows posted a record in January, Cassidy said. Purchases were almost break-even with redemptions in May, according to Lipper, a Reuters Group Plc company.

May asset flows was a concern, he said, as stocks were up in May. But the flow trend was not just in the United States, as European funds experienced negative flows, he said.

Though many purchases were in defensive plays, investors need to keep the big picture in mind, he said. The U.S. economy is still in the early stage of recovery, which means there should still be time for equities to move higher, he said.

Also, the pace of inflation is not expected to pick up considerably, so the Federal Reserve (search) is unlikely to quickly push interest rates higher. With a moderate rise in interest rates, that should make equities attractive, Cassidy said.

And, companies continue to deliver strong earnings, while stocks show improved valuations. The S&P 500 is priced at prospective price to earnings ratio of 17, near the lower end of its 10-year range and below its average of 21, Lipper said.