Looking more like a marathoner at the end of a race than at the beginning, the financial markets limped into the end of the quarter in rather nondescript fashion. For all the hoopla over the third and fourth quarter’s pickup in activity, the second quarter’s economy was certainly nothing to write home about. Even the anticipated Fed cut of interest rates failed to rally the troops, instead left many wanting more. Unlike the morning paper, little in the market is black and white. Those populating the unemployment lines were fewer, housing remained strong and consumer sentiment actually improved some. So now, after Monday’s close, the book on the second quarter is complete and the “better” third quarter will begin. We remain concerned that growth will remain below expectations and earnings may be a bit worse than expected. We will feel much better when the discussions begin to focus on Fed increases in interest rates, rather than cuts, as the economic condition will certainly be better. The Friday holiday will make this week’s trading a bit thin, and just maybe a bit volatile. Expectations for a continued correction are in place.

For the first time in June, the market finished a week lower. The correction has finally begun. While the market internals have been deteriorating for a couple of weeks, this week, prices actually followed the internals lower. Again, as is usual during turning points in the market, the short and intermediate term indicators are at odds. The daily data began turning lower early in June, while the weekly data has just begun to turn lower. We would expect that the next few weeks remain weak, as the daily data takes time to get to truly oversold territory. The weekly data could take another quarter before registering a potential “buy”. Opposing all the potentially negative readings on the market, one indicator that has a good long-term record continues to point to a positive third quarter. The indicator simply depends upon short rates and dividend yields. It points to an average quarterly return of 5% for the coming quarter, has been positive 70% of the time and has two-thirds of the time will fall into a –4% to +13% range. Over the past seven quarters, six times the signal has been positive, with two (the current quarter and 3q02) falling outside of that range. Lower rates have been helping the market (unlike early in the bear market), while investor sentiment has been at or near historical highs. Cross currents galore! We remain on the side of caution as few economic signs of growth are around. While the quarter indeed may be positive, the early summer may leave investors wanting.

The long bond, contrary to the Fed’s actions last week, continued to back up; adding 40bp to yields over the past two weeks. As a result, the yield curve has once again steepened back to mid-April levels. If the recovery is to get any traction, the yield curve will need to flatten out, as it did prior to the ‘93-94 recovery. If inflation is really a concern (as indicated by the rate rise), the CRB index and gold don’t reflect it in their pricing, as both are lower since the beginning of the month. The bond model, for its part, remains positive at a reading of 4/5 indicators positive. Save for a couple of weeks in February, the model has been positive all year, as rates on both ends of the curve fell by 40bp. Until the model changes, the path of least resistance for rates is lower.

This week we will take one of our periodic reviews of the group work and note how things have changed from three months ago. One of the tenets of the model is that every dog has its’ day, and it is hard to stay king of the hill. Some changes occur quickly, others over longer periods of time. For example, the internet sector remained one of the top groups all quarter, and rose by better than 30% during the quarter. Such was not the luck of medical device companies that started the quarter near the top only to show a 7% return, half of the overall market. Heavy construction also performed poorly during the quarter after beginning on a high note. Those groups on the bottom faired pretty well, as tobacco, airlines and steel were among the top performers for the quarter. So what does the current “standings” of the groups indicate for the coming quarter? Deep cyclical companies are among the dogs, steel remains, trucking, rails, paper and tires, all hoping to have a better quarter. The current residences of the top spots may fair poorly during the coming quarter: internet services, wireless communications, biotech and communication tech. All the former high flyers of the late ‘90s are showing up again, and unfortunately have little in the way of earnings to support their huge runs. If the sector work is correct, there may indeed be an economic recovery, however based on their present standings; it doesn’t look to be in the near future.

The return of small stocks last week has put our weeding of the weak on hold for another time. We are content to stand pat and see if/how the market correction develops before making any changes. It should be a slow trading week, with low volume and potentially large price moves as many traders head for vacation early. Due to our heavy weight in small stocks over the quarter, we have been able to keep pace with the averages holding extra cash and a bit of a short position.

© 2003 Paul J. Nolte, CFA
Editorial Archive

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

CONTACT INFORMATION
Paul J. Nolte, CFA
Director Investments
Hinsdale Associates
630-325-7100
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