Long periods of inactivity punctuated by a flurry of activity – although describing fishing, it also does a decent job of describing the stock market during August. Much of the activity during the day has occurred at either end of the market day, with long dull periods between the open and close. Once the markets react to the daily news, little follow through occurs as many traders are getting the last bits of sun away from the once frantic markets. The economic news has begun to point to an economic slowdown (finally??) that we had been anticipating since the opening of the year. Durable goods, a very volatile series took away much of the gains of the prior month and housing is showing some signs of slowing down. While the housing bubble burst has been anticipated for over a year, it has been foremost in the comments from soon to retire Fed Chairman Alan Greenspan. In what was more of a farewell party, the annual concave at Jackson Hole, Greenspan reiterated his belief that those over leveraged and over paying for housing will be hurt at some point in the future. What was left unsaid is that the Fed is watching “asset prices” (read real estate) to determine when to stop increasing rates. So we have likely more rate hikes in our future, making the likelihood of a recession that much greater.

While a break from the markets is always a good thing, it also allows some distance to better see the trends within the markets. The rally from the April lows remains tenuously intact, as does the trend from the lows in ’03. However, the SP500 has had trouble staying above 1220 and with a break below 1200 (now at 1205), it is in jeopardy of falling to 1160 and then 1090. If we look at the weekly data, many of our momentum models have rolled over and if history is a decent guide, it will be another six weeks before we see a meaningful bottom (hopefully around the above figures) in the market. One development that has been very slowly unfolding over the past three weeks is a strengthening bond market and weakening stock market. If the trend continues to unfold, we could see bonds outperforming stocks for a period of months, not just a couple of weeks. Little has changed during August to many of the trends we have been commenting upon over the past months – volume has tended to be higher on declining days, our “smart money” indicator has been pointing to a deteriorating market all year. While many of our indicators are not “act now”, they do flag situations that will take time to unfold. The market return has equaled that of earnings growth – meaning last year’s expensive remains so today.

The bond conundrum continues, higher short rates, stable long rates. The decline in long rates recently was enough to push the bond model back to a positive “3” reading, indicating long-term rates may continue their decline. The flattening yield curve remains a concern, now just 80 basis points between 13-week t-bills and 30-year bonds. The curve is now in the “normal” range of the mid-90s, however if the curve flattens to 35 basis points or less (like it did in ’00), we would use it as a signal to severely reduce our equity exposure and increase the likelihood of an imminent recession.

© 2005 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.

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