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Third Quarter Outlook



Originally published 6/30/03 by FTN Widwest Research

• The broad market appears set for some early quarter gains due to oversold condition
• In order to mount anything more than a retest of recent highs, more intermediate-term consolidation is needed
• Expect a period of rotation that should favor more defensive sectors

What a Difference a Quarter Makes. The markets began the second quarter with a war underway, sentiment in decline, economic uncertainty, a weak domestic currency, deflationary fears, and the equity market just beginning to bounce off the lows. If I told you the S&P 500 (SPX) and NASDAQ Composite (NAZ) would have staged such a dramatic recovery, you would have told me that I was crazy (although that has nothing to do with the market). Stocks were depressed and very few anticipated the kind of equity market recovery that was forthcoming.

2Q Review. As investors approached the second quarter there were very few compelling reasons to buy. The fundamental outlook remained unchanged and the ongoing War created a feeling of uncertainty that kept consumer and business spending in check. I like to refer to the second quarter surge in stocks as the "it's not going to zero rally." I use that phrase because the gains didn't come from a huge upswing in earnings driven by broad based economic improvement, but came from overly pessimistic expectations pressing stocks to the downside, especially given the dramatic decline in rates as the quarter wore on.

The most interesting action wasn't in the government bond market though, in wartime you would expect a flight to quality, but was in the corporate bond market. Despite the lower level of confidence and the less than robust economic news due to the war, corporate debt securities were experiencing significant gains throughout the quarter. This basically was the first time in the last five years that corporate bonds were moving in the same direction as government bonds - despite a news backdrop that didn't seem to deserve it. Clearly institutional investors were not betting on the "worst case scenario" being the likely case scenario.

As it became evident that the worst case war and economic scenarios weren't the most likely case, investors felt the need to participate by buying beaten down stocks relative to realistic expectations. In other words, look for the stocks that were priced like a bond default or bankruptcy was around the corner. As the rally in corporate paper progressed, it received more attention and caused equity investors to alter what could only be seen as too pessimistic a view, forcing money into the equity market.

That Was Then, This is Now. The reason it is so important to look back at what generated the gains, is because it has a lot to do with what could drive the equity market moving forward. If the broad market was up because expectations were overly pessimistic from a geo-political, economic and corporate framework, should stocks continue to surge when that is no longer the case? Not in my view.

The markets begin the third quarter with relative geo-political calm, sentiment advancing, a stabilized currency, economic improvement and stocks just shy of recent highs, which represented nearly a 20% advance from the beginning of the quarter. In addition, there is no question that investor sentiment has improved as the survey from Investors Intelligence Inc., suggest that market optimism is the highest since early 1987. Clearly, the "it's not going to zero" rally has been more than discounted. Does that mean that stocks have to experience a significant decline from current levels? Not in my view. The market is entering a transition from perception to reality. How that transition progresses should determine the next "major move" in stocks.

Conventional wisdom suggests that no matter what the environment, the "next move" in stocks is going to be major. I guess this comes from people like me feeling compelled to make the next "big call," even if it doesn't exist. Strong markets tend to work off intermediate-term overbought conditions by moving sideways in a range vs. experiencing significant declines. No matter how you feel about the sustainability of the second quarter rally, this has been a very powerful market in terms of price, breadth and sentiment. In my view, this would be a great time to outline some of the supportive and resisting factors that should keep stocks in a new higher trading range.

Factors supporting the market:

• Last weeks rate cut and commentary by the Federal Reserve buys time for the transition from perception to reality. In other words, if the economy doesn't show significant enough improvement over the next few weeks and even months, investors could argue there hasn't been enough time for the recent lower rates (Fed and Market driven) to favorably translate into improved economic conditions.
• Increased access to the capital markets should enable companies to continue to shore up balance sheets and have money necessary to grow.
• Signs of economic improvement have emerged over recent weeks. This week's employment and ISM numbers should shed some more light on economic progress in a post war environment.
• Geo-political tensions, while still high, have eased dramatically over the past quarter removing this issue as an excuse for staying on the sidelines.
• The low interest rate environment and view that real estate has become too pricey leaves very few alternative investments to equities.
• The major market indices such as the SPX and NAZ have entered into oversold territory (based on a 14-period stochastic indicator) due to the recent corrective period in the context of an uptrend (Exhibit 1&2), which is normally a reason to buy.

Factors resisting further upside on the market:

• The economy, while showing signs of improvement, has yet to show a clear and sustainable trend higher.
• Valuations are not cheap, even considering the low level of interest rates. This can be resolved two ways - (a) dramatic fundamental improvement and sideways action in the equity market making stocks less expensive, (b) the market gets smoked and the fundamentals remain constant. Obviously, I am in the (a) camp, but again it means taking a break in the upside.
• The upcoming earnings season is likely to highlight stabilization in the fundamentals, which is a positive near the lows, but is unlikely to be considered a reason to buy after a 20%+ rally.
• While the market is oversold in the context of an uptrend on the near-term charts, it is overbought and losing momentum in the context of a downtrend on an intermediate-term basis (Exhibits 3&4), which is normally a reason to take profit.

Summary. In my view, there are basically three phases of a sustainable market advance; perception, trading range and reality. Clearly, the last quarter was marked by the perception that access to the capital markets and lower interest rates would lead to fundamental improvement. Now the market should enter a trading range where there is a transition from perception to reality. In order to successfully navigate this transition, the intermediate-term overbought condition should to be resolved without too much technical damage and signs of an economic acceleration, especially in business expenditures, should be seen over coming weeks and months. That likely means some profit taking in the areas that gained too much too soon, and money flowing into areas that are more defensive until economic acceleration proves to be a myth or reality. Either way, it seems like a good time to rotate defensively on any retest of recent highs.
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