Welcome to the fourth quarter. The initial debate between Sen. Kerry and Pres. Bush are in the books (and the handicapping has begun), the first quarterly decline in a year and a half is also now history. So how did the markets greet the beginning of the final quarter of the year? The opening strong rally in stocks (and decline in long rates) may be the first salvo in what historically has been a good quarter for equities. The economic news released last week was in line with expectations, however the Purchasing Managers report indicated that employment growth should be toward the higher end of expectations when the unemployment report is released on Friday. Expectations are for modest growth of 150,000, which may not be enough to break the declining trends of the past four months. IF the report comes in well over 200,000, we would expect a strong rally in equities, however much below 100,000 could put a rapid halt to the euphoria surrounding the markets after Friday’s close. The technical picture (outlined below) is improving, however the market multiple remains at or above historically high levels. So, in the short-run, the markets may continue to rally, but we view it as a rally in a much broader declining market.

The griping we have done over the past months about volume, either lack of it or persistence of declining to advancing volume may have to end. The past two weeks have, for the first time in a year, pushed our volume indicators into positive territory. The net advancing to declining issues have been rising for the past two months on the strength of fixed income surrogates that populate the NYSE. Today, unlike any prior rally over the past year, the volume indicators are confirming the rally. This is occurring in the face of higher oil prices that have kept investors “nervously optimistic”. While we are on record as believing higher oil prices are inevitable, they are not as a key part of the economy as they were just 10 or 20 years ago. By themselves, we believe, higher oil prices will not be sufficient to push the economy into recession. However (and it is a big one), if the Fed is successful in slowing the economy by raising rates, persistently higher oil prices could exacerbate whatever slowdown the Fed is trying to engineer. We will be watching Monday’s action closely for some keys to the potential length of the rally.

Huge gains in the commodity complex (led by oils and metals) and a jump in the long bond as investors reevaluate the economic picture were not enough to push the bond model into negative territory. Still positive at 3/5, the model is pointing to lower rates in the months ahead. Also, for the first time since the model turned positive in June, the equity markets have become positive. Historically, there has been a positive relationship between the model and equity prices that for much of the period beginning in 2000 was negative. If the relationship can hold, we may be able to argue more forcefully for higher equity prices.

With Friday’s strong move higher, stocks ranging from Altria (MO) to Caterpillar (CAT) to Lexmark (LXK) put in reversal weeks, with a lower low than the prior week, and a higher high, closing near the weekly high. So what does it mean for all these reversals? The key will be Monday’s trading, if the gains can be build upon, a more sustained move is in the offing. We mentioned the chemical group last week, and Dupont (DD) was among stocks reversing higher. Dow (DOW) looks to be the leader of the group, pushing to multi-year highs, after trading in a 12-point range for the past 8 years. The new high clears the way for move to the mid-50s over time. DD continues to be range bound, however in an ever tighter range. A close above 45 should put an end to the range, and maybe some catch-up with others in the group would be in DD’s future. The announcement by Merck (MRK) of termination of their Vioxx drug put additional pain on a sector that has already been hurting. The consumer group has been hurt by preannouncments from Coca Cola (KO), Unilever (UN) and Colgate (CL). What has been a safe haven during poor markets has been exposed as having landmines as well. The turning of the technical picture to a better outlook may allow investors to rotate toward the more “juiced” stocks in hopes to achieve high returns for short periods of time. With technology stocks mired in their own renewed bear market, the may actually get some play in the weeks ahead as investors rotate from the better performing stocks to those that have suffered.

The strong rally on Friday punctuated a two-week period of better relative volume, a part of our work that has been negative for over a year. While we are becoming more bullish on the market due to seasonal, historical and technical reasons, we caution that the bullishness may be fleeting, as the fundamental picture remains negative as stocks remain expensive from a long-term perspective. Any shifts we may implement in the weeks ahead will be done with an eye toward the door. For if we are successful in squeezing out a 5-10% gain from a year ending rally, we may take our money and run.

© 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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