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What's up with that!?


Yesterday again proved that this is a difficult tape to figure out. Just when you thought that someone trumpeted the all clear sound for the rally to continue, we were again reminded that the market's (or a stock's) reaction to news is driven many times by how it trades into the news. Before the opening yesterday, there was strong upward momentum in the equity futures and weakness in bond futures due to stronger than anticipated post-Thanksgiving day sales by retailers. In addition, a highly regarded semiconductor analyst said to buy chip stocks now as the fundamentals were showing signs of improvement. All looked good for the bulls as trading was set to open.

Then came the ISM report (institute for Supply Management), which measures activity at the manufacturing level. While the reading was better than the prior month, it still was indicative of an economy on the edge. It took a little while for the reality to set in, but then it did and despite the good news in the early going, the market closed mixed for the day. How could that happen? If the market doesn't react to good news then it surely should react to bad news right? How could it close mixed?

This is where it is essential to understand the perception trade vs. the reality trade. Since the beginning of October, the equity markets experienced significant rallies that have been very similar to a year ago at this time. The Dow Jones Industrials (DJIA) and S&P 500 (SPX) are up more that 20%, while the NASDAQ Composite Index (NAZ) has gained greater than 30% - all in just over seven weeks. While this sounds extraordinary, it is very similar to the gains after the post-9/11/01 lows. Much like this years run, that rally was sharper and longer than almost anyone expected. Both were based on expectations for better economic and corporate profits growth rate down the road due to aggressive Fed rate cuts, a quick end to a military conflict, limited inflationary pressures, consumer confidence that "couldn't get any worse" and some stabilization of the tech spending environment.

In the fourth quarter of 2001 the perception was that things could only get better. That perception drove the DJIA and SPX up greater than 20% directly after the terrorist attack, while the beaten down NAZ surged over 40%. This rally, much like this years, came from very oversold levels on all three time frames - daily, weekly and monthly. Anyone who was looking to sell had more than enough time to do so and that was evident by the carnage. Sound familiar to early October?

Then the reality came in early 2002. Those very factors that led to the pain since the beginning of the secular bear market still did not have an identifiable conclusion. Economic growth was suspect, the President told us the War on Terror was going to last much longer, valuations were not cheap based on bear market standards and the very people who could tell us things were going to get better - analysts, CEO's and accountants - were being carted away in handcuffs. Despite the perception that things would get better, the reality was they didn't, and as a result stocks made new lows. There was no identifiable conclusion to any of the longer-term issues and the market was forced to react.

Basically, if there is no way to gauge when something will end, how can one ascertain whether or not it is priced in? For example, historically it is very positive for the stock market when the Federal Reserve begins to lower short-term interest rates because it ultimately results in increased economic activity and therefore growth in corporate profits. It again appeared to be working when the Fed began lowering rates toward the end of 2000. The perception was that it would work again - the reality was that it didn't. Now that that paradigm failed in its most recent form, how can we accurately determine that the probable outcome to the most recent dramatic rate cut? If all the prior cuts didn't work, how is this last one going to?

Truth be told, you can't tell what the outcome will be because it is something that has to be proven and is too far away. The market surges expecting the historical outcome and then adjusts to what the actual outcome is. If it is better, then the market continues higher (1991), if it is worse, the market heads lower again (2001).

My main point here is that the market has entered the twilight zone between perception and reality - that place where the surge has happened, and we are now waiting for the news to back up its validity. Again, going back to last year. The market experienced the vast majority of the gains by the first week of December and then basically fell back and retested those highs a couple of times before beginning a descent to new lows that began in March. That's right folks, it didn't make sense to either be a bull or bear between the first week of December to the beginning of March.

We know the perception side of the equation; lower short-term rates, limited inflationary pressures, better economic expectations next year, expectation for a quick resolution to any Iraqi conflict and signs of stabilization in capital spending patterns. Now the question is whether you are determined enough that those factors will play out even better than the perceived outcome because that is what will be needed in order maintain (much less improve) current valuation levels and justify buying stocks here.

This is the point in the market where each of you as an individual need to reassess your portfolio and ask why you own certain stocks and what the best course of action is going into next year. Only you and your financial advisor can do that.
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