Like the smitten young man, Bernanke gave the financial markets a large bouquet of roses and a few pounds of chocolates for Valentine’s Day. And the financial markets swooned as any young lady would and jumped over one percent, retaking record high ground in many of the major averages. It didn’t hurt either that takeover activity remained strong, with overtures to Alcoa as well as Daimler Chrysler. The economic news was fair at best, with the housing market still struggling, after many declared housing fit to go to the dance. The coming week will have a few economic figures and little from corporate earnings to drive the markets, so we will be looking at company specific news, from takeovers to stock buyback activity. After showing some robust economic growth during the fourth quarter, the revisions should take actual growth back below the magic 3% level, as inventory and trade activity will work against domestic growth. So activity coming into the first quarter doesn’t look as good and the recent reports were not terrific making the overall growth rate in the first quarter likely to come in around 2%, well below the desired levels by the Fed – what happens next will be Bernanke’s call.

The “Bernanke rally” pushed many of our daily indicators to over bought, however, as we have mentioned in the past – over bought doesn’t mean the market reverses lower. We have seen both last week and the week prior where the markets take a couple days rest – seemingly doing nothing all day long, before another surge higher. We are concerned that this rally is occurring on lower volume, with the last two weeks coming in well below average. Since volume represents investors’ conviction, fewer participants are pushing stocks higher. The very steep ascent of the market since the July lows (at a better than 30% annual clip) could use a break, but they have been short and very shallow (declines have been less than 1%). We believe the combination of slowing economy (and earnings) should force the market lower given the very high market multiple. But from what level and when remains the $10k question. Until we see more cracks develop in the stock market, the status quo rules the day. The smaller and mid cap stocks have also regained their form and are actually leading the markets higher.

Although Bernanke declared, in not so few words, that the goldilocks economy is alive and well, the bond market actually rallied all week, however the short-term bonds remains stubborn high at multi-year highs. The longer end of the curve rallied, forcing a steeper inversion of the yield curve (now at it’s most negative since Thanksgiving). We still believe the inversion in the yield curve points to slower economic growth, however an inversion of more than 60 basis points would ring a loud bell (currently the curve is 37bp inverted). The bond model remains positive for the second week, indicating we should see lower rates in the weeks ahead – a difference from the prior two months.

© 2007 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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