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I got THAT look

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As I drove in this morning, all was quiet as I drove over the GWB heading into the office. My car pool partner Linda gave me that "look" she gives when it is obvious that I am grinding about something. My initial thought was "what are you looking at?" followed immediately by "she is right and lighten up Francis (refers to line in "Stripes" with Bill Murray)."

There is an awful lot to grind about in the financial markets right now; geo-political risk (Iraq), Economic uncertainty (retail sales), and profit concerns (Micron Tech: MU) as we approach the Q4 pre-announcement season. And then of course we have the dicey technical environment that exists as most major indices and the stocks that comprise them are at or very close to key support levels.

First, lets address fundamental issues. THEY HAVEN'T CHANGED SINCE THE OCTOBER LOW!

· Geo-political - Did anyone really expect Iraq to come clean and 'fess up to everything in their 12,000 page document. Did anyone expect the President to suggest that he is a good guy and not to worry it will all work out? One way or another, there is likely to be an attack and that comes to the forefront now because the equity market has lost momentum - not because the situation changed, in my opinion.


· Economic - As I was on CNNfn for an hour yesterday, I heard a number of times how stocks are down because of economic concerns. The point that I tried to bring out was that if the Fed cut short-term interest rates by a greater than expected 50-basis points to just 1.25% on the Fed Funds rate in the current quarter, how would anyone expect improved economic results in the same quarter? The Fed cut rates because there was economic risk to a move back toward recession, not because the stats were suggesting improvement.


· Corporate profits - Please refer to the directly above bullet point. Many times I have heard the argument that corporate profits are already improving. That is absolutely right, but I think we need to look at the main reason behind the improvement. Profits have grown because of massive cost cutting vs. a return of demand led revenue gains. Oh and there is that general distrust of the numbers being talked about anyway, whether from the companies themselves or the analysts that cover them. That hasn't changed since early October either.

Now lets look at the structural issues.

· The reasons for the 20%+ gains in the S&P 500 (SPX) and Dow Jones Industrials (DJIA), and 33% gains in the NASDAQ Composite (NAZ) between the October low and early December high were likely structurally based. The market had become very extended to the downside and as a result, there were fewer seller left. That opened the door for short covering. That is like corporate profit improvement coming from cutting cost vs. better revenues. When shorts cover, it isn't because they "like" stocks, it is because they want to either take some profits or reduce risk when their bet has been sooooo right. While short covering is buying, it doesn't represent real interest in stocks.

· Throw on top of the short covering some asset allocation moves. Basically many funds have a predetermined range they want to have in bonds, stocks and cash instruments. The historic rise in bond prices (generates lower yields) and drop in stock prices created the situation where the bond exposure was to high and stock exposure was too low. As a result, many had to move back to the predetermined range meaning that they were forced to sell bonds and buy stocks. It was formula based vs. valuation based.

I bring all this up because we are back to a prior situation, although not nearly extreme as in early October. The longs are scared (especially new ones), the shorts are excited and don't tell anyone but the 10-year note yield is again back below 4%, which could bring back discussions of "out of bonds and into stocks" talk.

It is important to note that while the factors that led to the October low and subsequent rally have come back, the level is much less extreme as in October as I mentioned before. That is a key point because I continue to believe stocks could see an oversold rally that may allow for a retest of the early December highs, but that still means the vast majority of the gains are likely behind investors as the fundamental and geo0political concerns remain and intermediate-term momentum has been lost.

In sum, the message is two-fold. First, selling into a steep decline may feel right for a day or even a week, but may not be so right a few weeks down the road. Second, the intermediate-term indicators have lost momentum and the factors that helped cause the decline over the past year still do not have an identifiable resolution which means that any rally would likely stall and fail near the early December levels.

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Man I hate when Linda gives me that look!
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