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Comfort Zone



Today is the first day of the rest of the year. The market has spent the last three months in one of the tightest trading ranges in memory and has done so on shrinking volume. We have done quite a bit of traveling during that time and have come to the conclusion that we are very uncomfortable with our opinion there is significant upside potential from current levels. Clearly, the comfortable position would be to expect either a pull back or something more significant given the gains from the March low, current valuations and mixed economic outlook, but history suggests and we believe the next more significant move should be to the upside.

We would like to cover some key market points as we head into the end of the year...

Psychology remains "not bullish" - After traveling across this great nation, we have come to find that while sentiment isn't exactly bearish, it certainly isn't bullish. The prevailing sentiment surrounds a defensive posture, whether for fundamental or technical reasons. Valuations remain high, the market remains overbought, and after three long years of pain - no one wants to give back any of the gains and everyone is trying to be as neutral as possible. If you don't believe us, ask yourself the question; which direction will the next 20% come from in the PHLX Bank Stock Index (BKX)?

Odds are most of you would answer down due to the gains, interest rate environment and proximity to intermediate-term resistance (Exhibit 1). You can do the same exercise using almost any index right now, including the PHLX Semiconductor Index (SOX) (Exhibit 2) and S&P 500 (SPX). The key question is whether price resistance becomes price support if key zones are broken to the upside.

Exhibits 1&2 - Overbought and into resistance

Check Time Horizon. As we write this piece, we are overwhelmed with a sense of doom because we are in the two worst performing months of the year. September and October are the poorest performing months and the investment public has a working knowledge of risk during this seasonal period. We just heard for the billionth time on TV that September is awful with an average decline of 0.5% over the past 54 years. This is especially true over recent years because the mysterious "second half" recovery hasn't materialized. Could this year be any different? So far the recovery seems to be taking hold to the point where economists and analysts alike are being forced to increase expectations based on real improvement vs. perceived improvement.

What is important relative to expectations is that while many are raising the second half '03 forecast, there is limited change for '04. The prevailing sentiment seems to be that the economic recovery won't last even if it improves now. All too often the "wall of worry" is quoted by the various media and Wall Street establishments, but this is the first time since the early 1990's that there is an economic transition underway. In other words, if there were a time to climb the "wall of worry," it would be in an economic transition period.

Employment and Interest Rates. The obvious argument against upside for stocks surrounds the employment picture and spike higher in market driven interest rates. How can the economy recover if the unemployment rate keeps going up and there is limited employment growth despite the declared end of the recession over a year ago? While it may not be the norm, after the last recession the unemployment rate and employment growth picture brought similar concerns. Eventually the economy and therefore the employment picture improved (Exhibit 3&4).

Exhibit 3&4 - The employment picture seems a lot like after the last recession

In addition, there has been a spike higher in market driven interest rates. The rise in rates was dramatic by any measure and brought about commentary regarding the rate-of-change (ROC) and what it could foretell. Most commentary surrounded the fixed income and equity market reaction following such a high rate-of-change. The connotation was negative, which generally was true for a brief period. Ultimately though, when you drag out the time frame, whenever the monthly ROC on the 10-year was nearly this dramatic there was a little more pain, but it ultimately led to a period of bond market stability and ultimately strength (Exhibit 5).

Exhibit 5 - A high ROC ultimately ushers in a period of stability

The point here is not to suggest the best case scenario is going to happen for stocks and bonds, but there is a possibility further gains can take place given the skepticism in the market place. Each day we walk in we try to figure out what we are missing. In an environment where valuations are stretched, interest rates are spiking, either inflation or deflation is imminent, volume is shrinking and oil remains stubbornly above $30/ could anyone in their right mind be optimistic from current levels?

We never said we were in our right minds. For every negative force, there is the potential for that negative to reverse and become a positive. What if rates stabilize, employment improves with recent economic acceleration, oil drops to the mid-20's (acting as another stimulus), earnings surge as margins explode, consumer spending doesn't tank with limited refinancing and market volume picks up? Before you answer "impossible," think of how many times we have said that over the past five years in so many different ways.

We doubt all good things come to those who wait until they are comfortable because the last time everyone was at relative ease with the interest rate moves, currency fluctuations, commodity and earnings environment - it didn't turn out so well. Frankly, it isn't our view the backdrop is perfect. It is just the possibility that it isn't awful and may even get meaningfully better over the next year and could prop up stocks. Is it a new secular bull...we doubt it. Can there be meaningful upside from current levels in context of secular bear? Yep.

A move to SPX 1150, or nearly 15% upside from current levels, would only bring the market up to its prior lower high. In English, you can still be in a secular downtrend of lower lows and lower highs, but still get significant upside in between the two (Exhibit 6). I guess there is a possibility of being "right" and "happy" at the same time. So many are trying to figure out the secular move - the market hasn't even changed the primary trend yet. For reasons stated here, it could...but in reality focusing on the move to even test the downtrend (+15%) seems like the right course of action.

Exhibit 6 - Still in a long-term downtrend but with intermediate-term potential

Charts courtesy of Baseline and Reuters

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