Mirror Image?

With the Fed meeting behind us – and a long holiday weekend ahead of us – the markets are selling off today. Its about time, in our view. They’ve been overbought for quite some time now, and have withstood a lot of bad news with relative aplomb. In our opinion, we will likely enjoy an excellent earnings season, and strong employment numbers tomorrow. Considering how overbought markets had become in recent days, we believe the markets were long overdue for a healthy pullback – and it is finally here.

I had mentioned earlier this week that I thought we might see a mirror image of the first half of the year. It is worth explaining in more detail what we meant by that. The first half of 2004 began quite decisively. The rally beginning March 2003 maintained momentum right through the start of the New Year. After the indices made multi-year highs on January 26th, the steep (indeed, unsustainably so) up-trend was broken a week later.

At the time, we had noted that sentiment had become giddy about the same time that the Fed was slashing M2 money supply. That combination proved unhealthy, grinding the rally’s momentum to a halt. The sell off started out modestly, but accelerated, bottoming the week of March 22nd. With the indices quite oversold, a snapback rally saw the Nasdaq gain 80 points in less than 2 weeks. The Dow tacked on almost 500 points over the same brief period.

From oversold to over bought and back again: Buyers went on strike, stepping away as they digested awful news of casualties and a prison scandal from Iraq. Markets quickly became oversold, bottoming 6 weeks ago on May 17th.

The mirror image of 1H ‘04 might look like this: Coming into the second half of the year, markets were range-bound and listless. Overbought conditions and profit taking had combined with low volume, lackluster trading to bring about a short term low late in July. By the end of the month, the Democratic Convention had come and gone, and the markets had either become comfortable with the challenger, or less concerned about his potential for victory. Perhaps an “October surprise” came early. Regardless, the markets shook off their July malaise and moved slowly higher.

The Fed continues maintaining a high level of M2 Money Supply, as they had since the 2nd quarter 2004, which provided additional fuel for a grinding move upwards. In our view, it is quite possible that the markets may get a bit spooked heading into the elections, but muster a solid rally afterwards. We are projecting that the year closes with gains of 8-10% on the Dow and SPX, and 12-15% on the Nasdaq.

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