The preview to earnings season was nothing if not scary. The only bright spot occurred on Friday, as GE came in a penny better than expected and the markets mounted a half-hearted rally on the news. Comments from Yahoo, and analysts covering Intel put a lid on expectations of a booming quarter. What economic news there was did little for the market, however the coming week promises to be more fruitful. Inflation numbers, industrial production and one of the many reports on consumer confidence should be enough to either refute the weak employment figures or support a slowing economy. Expectations, judging by the reaction to earnings numbers so far, are high and although earnings numbers by enlarge should be met, comments regarding future business will be key to unraveling the future of markets. Rumors of terrorist activities around the conventions and election as well as oil price swings have been background noise to what investors are really focused on – earnings growth and interest rates. Contrary to popular belief, bond prices have rallied (rates declined) while stocks fell following the widely reported and much anticipated rate increase. This week we will get a reality check on the health of the economy and corporate America.

The technology driven OTC market and the broader SPX are beginning to diverge, not only on a price basis, but also on a technical basis. What remains to be seen is if the broader market follows the OTC market lower. No matter how you draw the trend lines, all the major averages have broken their upward sloping lines that began with the March ’03 bottom. Since December, they have all been range bound and as of yet have not meaningfully broken that range (For the OTC, 1900, SP500 1090 and the Dow - 9980), yet both the daily and weekly data is pointing lower. We had expected the weekly, or long-term data, to begin pointing higher, however with the recent sell-off, that hope has been shelved. We also expected to see divergences begin to develop, where the markets decline, but the technical picture actually improves – that too has not come into focus. Finally, our biggest concern remains volume, with last week a microcosm of the year – the highest volume day was a steep sell-off, and the lightest day was a rally from the weekly low. Support is eroding under the averages and unless reversed, eventually they look like they will follow “the troops” lower.

The bond model remains in positive territory at 3/5 indicators positive. Investors may be using the bond market as a safe haven spot for money while the equity market goes through its jittery period. The relative performance of bonds has been doing much better than stocks for the past month – rate hike notwithstanding. In fact, the out performance has been so strong that the bond market is back to its relative position vs. stocks that occurred at the May bottom for stocks. Put another way – the rally in stocks from the May low has been surpassed by the rally in bonds from that point - all the more reason to tread lightly in the equity market.

When the market breaks down, the usual suspects rise to the top. Utilities have gotten a double dose, with lower rates (even after a Fed increase) and an uncertain market. Consumer stocks, bastions in uncertain economic times are also rising. What is true on the upside is also true when the markets decline. Led by technology issues, the high-octane stocks are the quickest sold when the market sour. Since worries abound about the economic recovery, consumer cyclical stocks, especially retail issues have also been under pressure. What is interesting are the other sectors doing well – energy and basic materials. Both should be hurt by the specter of a slower economy, however with oil prices hanging around $40/bbl and drilling activity rising (although not at is recent quick pace) the group is still getting play. The basic materials, especially gold, may be playing recent weakness in the dollar. After bouncing off a steep sell-off earlier in the year, the dollar has been trying to stabilize for the past six weeks. Could the economic weakness and higher material/energy prices foretell a stagflationary environment? For our dollar, it is well too early to make that determination, but don’t be surprised to hear comments in the press regarding the possibility IF the inflation indexes reported this week come in strong while other economic measures continue weak. The best offense in the weeks ahead may just be a good defense.

The poor performance of the OTC market is giving us a reason to consider increasing our short position in OTC stocks, while maintaining investments in “SP500” type names. By our calculation, the OTC market is twice as risky as SP500 stocks, even though both may decline in the weeks ahead. Also, given the valuation differences between large and small stocks (in favor of large) we will also review our small cap holdings and may cut those further as well. The initial “break” of the rising trend line has not caused a decline in stocks; a break from their six-month range should push stocks at least 10% lower. The trigger points are outlined above.

© 2004 Paul J. Nolte, CFA
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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.

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