Anticipating the Dominant Stories

This year
began rather weakly. The markets first four months were a surprising
disappointment. That early weakness was broken by a reversal off of the April
lows. This most recent up-thrust and re-entry into the prior trading range
suggests to us that, after a period of risk aversion, a renewed appetite for
risk is underway.

While that
bodes well for equities over the intermediate term, markets have gotten a bit
extended after their recent drive. We expect a short period of consolidation,
as recent gains are digested, after some backing and filling. Traders should
look to leg into equities over the next few weeks, as the market pulls back
towards support levels of Dow 10,400, Nasdaq 2,000, and SPX 1,181.

A
significant part of this last up move has been fueled by Hedge funds. They are
collectively under-invested and under-performing. This creates a situation
analogous to May 2003, when the occasionally smart but always fast money was
looking to come from behind. That led to chasing Beta, rather than falling too
far behind. 2^nd H 2005 could see a similar phenomenon. Watch
internets, biotech and semiconductors as potentially hot sectors.

Recent
macro-economic events have given the Bullish camp a new line of arguments
supporting a potentially significant rally in the second half of the year. We
expect to hear the following bullish thesis:

· The
rate tightening cycle is almost done;

· The
bond market implies there’s no inflation;

· U.S.
Markets are cheap compared to everything else;

· Fed
model makes stocks appear 30% undervalued;

· New
round of housing refinancing will be stimulative;

· Look
how low unemployment is;

·
There’s no where else to put money except stocks;

Note that
we do not necessarily agree with many of these arguments. Indeed, we decisively
disagree with many of them. However, we are cognizant of the appeal they will
have to those who prefer reading headlines to dissecting the underlying data.
This is the source of our caution as to the a potential topping action in the
November/December time frame. 

As such, we
counsel legging in here slowly. Of the major indices, Nasdaq has looked the
strongest technically, with Semi-Conductors particularly robust. But its
over-extended, and that warrant a more deliberate capital deployment,
preferably, on dips. Our lines in the sand are now to the downside: Dow
10,400, SPX 1,181, and Nasdaq 2000. Those are your hard stops.