Sometimes, as you drift off to sleep, you are violently shaken as if jarred by hitting the ground or pulling back from a fall. The market has been lulled into a sleep as well, but every once in a while, a violent move reawakens investors to the possibilities and risks of the markets. In more than 50% of the trading days this year, the markets have moved less than one quarter of a percent from the prior close, and only 22% of the days have seen a move greater than a half a percent – without yet having a 1% daily move in the 36 trading days so far. The economic data has been signaling some warning signs, but so far many have ignored the housing “problem” – not so much the decline in housing value, but the crashing of some of the higher risk loan companies involved in getting marginal borrowers into homes they would otherwise not be able to afford. Like the technology industry and derivative investments before, the seeds of the next major decline are sown in the success of the prior periods. The full impact of the housing decline has yet to be felt, however it won’t be felt equally around the country (unlike the 100 shares of IBM we both own, your house and mine are very different). Let’s hope investors revive before the imminent jarring “wake-up” from the financial markets.

Even thought there continue to be risks in the economy as well as the markets, participants continue to be anxious to get into stocks. The short and very shallow market declines are usually seen as buying opportunities and last barely long enough for investors to establish positions in stocks. The momentum trades are being squeezed out, and the decline in volume as the market trudges higher indicate to us that yet another resting period is upon the markets. While we believe a decline is in order (based upon our various indicators), the magnitude of that decline remains an open question that will be better answered as the markets begin to decline. The markets have been “channeling” for the year, working in a rising channel that is marked by roughly 1442 on the bottom and now 1465 on top. There are a few break points below the market that may stop any decline – first being the 1442 mark, then 1430 and finally 1410 – then a long slide toward 1370. So we will be watching the initial levels to determine whether this is yet another run of the mill correction or we have something more significant on our hands.

The inflation report released last week was disconcerting if the focus was upon the headline figure, however bond investors took the figure in stride, not too worried that inflation would be back in a meaningful way. However, the continued deterioration in the yield curve continues to point to an economic slowing, not an inflationary spiral. The bond model remains positive at “3” and indicates lower interest rates ahead. For concerns over a recession to be high, we would expect the yield curve to be inverted by close to 60 basis points – today it is nearly 39 (up from less than 15 at the end of January).

© 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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