Gold Bugs, Rate Hikes, and Bears - Oh My.

If it isn't one fear, it's another these days. Every day in the financial news there is the specter of some other crises affecting the market, from gold prices to interest rates to weakening dollars to Y2K to advance-decline lines to moving averages to market analysts saying they don't care for the new fall television lineup. The markets are always concerned about something, which helps keep us on our toes, but right now if you do not have an ulcer you are doing well. More worrisome inflationary news came in today causing more bears to predict further declines and fret over another rate hike.

Stocks ended the week and began the fourth quarter on a negative note, although it could have been worse. After a brief relief rally yesterday, bears again took control and pushed the Dow and NASDAQ lower today, although both indices finished well off of their lows as some late-day bargain hunters jumped in. Ten of the last thirteen trading sessions have ended negatively. However, looking at figures for the week, the Dow was down only 6.33 points, the NASDAQ was down only 3.53 points and the S&P 500 index actually gained 5.45 points. These figures are somewhat surprising when you consider all of the negative sentiment and pessimism we are currently seeing.

Bonds took a beating today, hitting their highest level in six weeks. The benchmark 30-year Treasury Bond lost ground to close with a yield of 6.145, which coupled with a weakening dollar put pressure on stocks. The slide came as a result of a survey released by the National Association of Purchasing Management. The NAPM's factory index rose to 57.8 for the month, the highest level since November 1994, from 54.2 in August. Analysts were expecting a September reading of 54.4. An index above 50 means most manufacturers surveyed reported improved business and is interpreted as somewhat inflationary. The report ignited fear that the economy is growing too rapidly and might persuade the Federal Reserve to raise interest rates a third time this year. The following is a chart of the rising 30 year Treasury Bond yield.

Keep in mind that these types of reports are often leading indicators, meaning the effects of the increases might not be seen until well into next year, but here are a few other figures that show how strong the economy is. The index of prices paid rose to 67.6 in September from 59.8 during August, indicating more companies reported price increases during the month. Some of the increase is a result of high fuel prices. The production index, a gauge of current output, rose to 61.7 in September from 56.7 during August. The new orders index rose to 64.4 from 56.6 during August while the inventory index, a gauge of pent-up demand, fell to 43.2 from 46.6. Rebounding Asian economies have increased U.S. exports and strong domestic demand shown by increased consumer spending and personal income have just about ensured we will see our longest economic expansion ever reported in January.

While it seems counterintuitive to assert that a strong economy is bad for the stock market, it should be remembered that low inflation is one of the main catalysts of prosperity. The Fed has taken upon itself the reduction of inflation as its number one job in an effort to promote economic stability. They would rather see steady 2-3% growth every year than 5% one year and -5% the next. By trying to eliminate wide percentage swings, they believe everyone will feel more secure and prosperous. And as everyone knows, it is better to feel secure and prosperous than to actually be secure and prosperous.

The final figures for Friday show the Dow down 63.95 points, or .62% to 10,273.00. On the New York Stock Exchange, market breadth was decidedly negative, with declines ahead of advances by 1,804 to 1,253 on heavy trading volume of 897 million shares. The Nasdaq composite fell 9.31 points, or .34% to 2,736.85, and the S&P 500 index managed to crawl out of negative territory, finishing the day up 0.10 points, or .01%, at 1,282.81.

Today’s strong sectors were healthcare and drug stocks, utilities, and consumer cyclicals, and gold stocks. Eli Lilly rose 4.38 to 68.61 after winning FDA approval to sell its Evista drug for a new use in treating osteoporosis in post- menopausal women. Lilly might also be benefitting from sales of Prozac among traders. Amgen and Merck also posted strong gains after their respective osteoporosis drugs proved effective in tests. The S&P Healthcare Index rose 3.4% on the day. The index was also aided by HMOs, which rose after a federal judge dismissed a class-action lawsuit against Aetna, which rebounded 4.1%. The Dow Jones Utilities Index rose 1.1% and the Gold and Silver Index rose another 3.3% Chipmakers did well with the PHLX Semiconductor Index rising 1.9%.

Weakness was especially apparent in selected technology, transportation and financial stocks. Hewlett-Packard announced fourth quarter sales will come in at the low end of estimates following disruptions from the earthquake in Taiwan. IBM and other tech stocks fell in sympathy. The Dow Jones Transportation Index dropped 1.4% and the PHLX/KBW Bank Index fell 0.90%.

Without a crystal ball it is impossible to know which direction the market will go in the near term. There are, however, a few contrarian indicators that help make things interesting. First, market breadth is so bad it might be good. The volatility index is high, and bearish comments are everywhere on financial television. Many times during market declines, the short-term activity is determined more by herd mentality rather than fundamentals. Pull out your old mass psychology texts and you may be better off than those watching CNBC. Contrarian indicators are not usually good for picking exact bottoms, but it is often darkest before dawn. The questions to ask here are "how dark is it?" and "can it get darker?" which it probably can.

Be careful not to get caught in a sucker’s rally, bear trap, countertrend rally, or whatever else you might want to call it. These are brief rallies that come during a downtrend, giving investors hope that the trend has reversed and there is easy money to be made by getting in now. Some who let greed get the best of them jump in with both feet, hoping to make a killing by buying at the low. Every downtrending market has several of these, each one leaving a host of broke traders in its wake. A better strategy for investors, particularly if their time frame extends beyond the next few weeks, is to either wait for a confirmed bottom, or to allocate a fixed percentage of one’s available cash at a particular level. For example, invest 20% at every 100 point NASDAQ or 500 Dow point drop. Averaging down will leave you in a better position when the market does turn around (unless of course a massive bear market cuts market levels in half, then you lose your money either way).

On Tuesday the FOMC will meet to decide whether interest rates need to be adjusted. Although most Fed watchers do not expect a rate hike, they are less certain than the previous two meetings. There are certainly some signs that inflation pressure is mounting and Greenspan & Co. have been hawkish for the last six months and could easily surprise the market's best and brightest. Contrary to common sense, an interest rate hike might actually be good for the market. Traders might actually see such a raise as a stabilizing force since the Fed would be unlikely to raise again this year, and the reduced uncertainty may persuade some sideline cash back into the game. In any event, it would behoove one to be careful taking positions before announcements.

Regardless of what the Fed does, earnings always drive the market and earnings still look good for the third quarter. The long- term outlook for the market is good, but over the next few weeks and possibly months things look shaky.

Good luck and happy trading.

C. Polson
Research Analyst