Walter Deemer's Weekly Report - January 3, 2003


SUMMARY AND CONCLUSIONS. January is a pivotal month. If the stock market stages a strong advance, as we expect it to, the cyclical bull market will be very much on track. If it doesn't, though, we'll have to reassess the situation in early February. Big NASDAQ stocks, meanwhile, are providing short-term leadership for the market, but its longer-term leadership should come from mid-cap and small-cap stocks.

JANUARY IS A PIVOTAL MONTH. The stock market made a benchmark low in July, with 943 new lows, volume of 2.7 billion shares and a record amount of margin calls. It then staged a normal-looking test of that low in October on lower volume and with fewer new lows. All this fit in neatly with the four-year cycle; the market's well-documented tendency to make a major low every four years, since the next such low was due in 2002.

July-October, then, should represent a four-year cycle low in the stock market. So far, though, the S&P has rallied only 20.9% from its October low, putting the rally in the same league as the bear market rallies of April-July 2001, October 2001-March 2002 and July-August 2002 (top chart, next page). Also, the post-October rally has not yet carried the S&P above its August high (963), and the index's series of lower highs thus remains intact. In addition, one of the two classic hallmarks of a new bull market, breakaway momentum (the 10-day total of NYSE advances exceeding declines by more than 1.97-1), has not yet appeared, and although the market did finally generate a 90% Upside Day yesterday (upside volume was more than 90% of upside plus downside volume AND points gained were more than 90% of points gained plus points lost), the fact that the 90% Upside Day occurred on such light volume, as discussed in The Market Now, lessens its significance to some extent. (The market also generated a 90% Upside Day on July 5th on light volume, which was three painful weeks before the bottom). Whatever the case, it is essential that the S&P rally above its August high, 963, at some point to generate a higher high and thereby confirm that this is not just another bear market rally.

The odds, fortunately, favor a strong rally in January. Fully half of the breakaway momentum-generating rallies have taken place during the month of January, and there thus appears to be a tendency for the market to generate a strong rally early in a new year. The market's month-long consolidation/correction has also set the stage for a rally, and the long-term indicators are in position to support one here as well. (Note, for example, the recent surge in M-3 on the bottom chart on the facing page). And, finally, the current environment feels like a major bottom, with widespread investor despair, a widely-telegraphed war on the horizon, ad infinitum. The market should thus rally - probably strongly - this month.

As we learned from the dog that didn't bark in a Sherlock Holmes tale, though, markets that don't do what they are supposed to do are trying to tell us something. If the market does not rally in January, then, similarities with the rally failure last February and March, which led to the disastrous tailspin of the following three months, will start to rear their ugly heads. The bullish cyclical forces are thus battling some non-bullish secular forces here; the bullish cyclical forces should win the day - but we are not going to take a Pollyanna attitude if they don't.

"But what if we are in the midst of a secular bear market?", you ask. Even if we are in the midst of a secular non-bull market, a la 1969-1982 - or something even worse than that - the stock market should still stage cyclical advances along the way. There were three four-year cycle lows, for example, during the 1969-82 secular non-bull market (1970, 1974 and 1978). Each time, the S&P staged a full-fledged cyclical bull market afterwards: 50% in 1970-72, 75% in 1974-76, and 39% in 1978-80. Even more importantly, investors who were in the "right" areas of the market did even better; a "Nifty Fifty" growth stock average rose 40% in 1971 and 42% in 1972, and the Russell 2000 index (which is where we think leadership will be centered, together with mid-cap stocks, during the upcoming cyclical bull market) more than doubled during both the 1974-76 and 1978-80 cyclical bull markets.

And even if you are a long-term super bear, there is still reason to expect a good rally here. According to Ian McAvity, a brilliant long-term market historian, the 1929-32 bear market lasted 148 weeks from top to bottom, and the market then nearly tripled from mid-1932 to mid-1933, and the Tokyo Crash of 1990-1992 was 137 weeks to the August 1992 low, from which the Nikkei bounced 50%. The October low for the NASDAQ was 136 weeks from the peak - and if you line up the 1929 top with the NASDAQ peak in March 2000, the equivalent date for the 1932 low (148 weeks later) is the week ending January 10, 2003.

All the evidence, then -- from the short-term through the secular -- thus suggests, quite strongly, that the market is going to stage a strong rally here, and we see no reason to think it won't. Like the dog that didn't bark, though, if the market does not stage a strong rally within the next month, we will have to make what will be a rather agonizing reassessment of the situation in early February.

THE MARKET NOW. The market has been consolidating for the past month or so, and both seasonal factors and the short-term evidence indicate that it could start a new upleg at any time now. The traditional sign that a consolidation has ended and a new upleg has begun is a powerful up day: a day when advances are more than 4 times declines, upside volume is more than 9 times downside volume, and total volume is more than 2 billion shares. We got some - but not all - of that confirmation yesterday; upside volume was 15 times downside volume, but advances were only 3.5 times declines. The real clinker, though, was that total volume was a very light 1.23 billion shares. The market also generated its first 90% Upside Day since July 29th in the process, but the unusually light volume brings back haunting memories of the 90% Upside Day on July 5th, which was three painful weeks from the bottom.

The key to all this is whether the market can generate some followthrough to yesterday's advance during the next few days. The fact that there was no significant follow-through today indicates only that this is probably not a breakaway momentum-generating advance, since almost all such advances in the past have had very strong follow-throughs on the second day. The market, though, often goes through a period of indecisiveness at the beginning of a new year while the turn-of-a-year cross-currents subside, so the short-term lack of follow-through here is not significant. What would be significant is if the advance doesn't try to reassert itself fairly quickly via another strong up day - and, this time, on some more decisive volume. If it can, we may just have that strong January rally we have wanted to see so badly; whatever the case, we will keep you posted as this pivotal month unfolds.

LEADERSHIP. Big-cap stocks traditionally lead the early stages of a new bull market, partly because they are the easiest to buy and partly because they are usually the hardest-hit during the final stages of the prior decline. This advance is proving no exception; the recently-beleaguered big-cap NASDAQ stocks have been leading the rally thus far, and look like they will continue to do so for a while yet. Mid-cap and small-cap stocks, however, are showing encouraging strength at this early stage of the bull market, since they normally save their best performance for later on, when investors' confidence has had a chance to rebuild and their appetite for easily-buyable stocks has been satiated. In addition, mid-cap and small-cap stocks made a secular low in terms of relative strength in 1999, as the charts on the first chart page in the back of the report show, and their new secular relative strength uptrends remain very much intact at this point. Since mid- and small-cap stocks traditionally do better and better as a bull market progresses, we expect these areas of the market to take on more and more of a leadership role as the bull market unfolds.

BEST IDEA OF THE WEEK. Value Line recently elevated Qualcomm to a "1" ranking. Big technology stocks have been conspicuously absent from Value Line's list of their 100 top-ranked stocks, and Qualcomm thus appears to have something atypical going for it from both a fundamental and a technical standpoint. Qualcomm thus becomes our Best Idea Of The Week this week.

STOCK COMMENTS. As just noted, Value Line recently elevated Qualcomm to a top "1" ranking, making it one of the very few big tech stocks to be so ranked (the others are Dell, eBay and Nextel). Amazon and Intuit are also generating atypical strength in this long-beleaguered area of the market. If you're looking for buy ideas in the big-cap tech stock area, then, these stocks appear to be the place to start, since they are the best-positioned to lead a long-overdue NASDAQ recovery. Also, gold recently broke out to a five-year high, but gold stocks have not followed suit. Since the stocks usually lead moves in the metal itself, the upside breakout in gold is somewhat suspect at this point.

OUR OWN MONEY remains fully invested in mid-cap and small cap funds via positions in Phoenix Small Mid Cap, PKSFX, a mid-cap growth fund, Vanguard Selected Value, VASVX, a mid-cap value fund, Perkins Opportunity Fund, POFDX, a small small-cap growth fund, and Acadian Emerging Markets Portfolio (AEMGX, which I consider a small-cap fund). My Fidelity Select money is also 100% invested via positions in the Multimedia (FBMPX) and Telecommunications (FSTCX) funds plus a position in the PIMCO RCM Biotechnology fund (DRBNX; I switched from Select Biotech into DRBNX last summer for tax reasons).

THE BOND MARKET. It is looking more and more like the bond market made a very significant high in September-October given things like the heavy recent inflows into bond funds (inflows which are disturbingly similar to the inflows into Janus-type funds in 2000) and the bond market's recent break of its long-term uptrend line. In addition, bonds usually perform worse and worse as the economic cycle turns back up, so about the best thing we can see for bonds here is a wide-swinging trading range between their September highs and their October lows. Whatever the case, stocks appear to have much, much more upside potential than bonds here. (We should note, though, that the foregoing comments apply only to Treasury bonds; other areas of the bond market, particularly junk bonds, should perform much better than Treasuries at this stage of the financial and economic cycles.)

BEST AND WORST GROUPS. Charts of the four best and worst-performing groups during the last seven weeks may be found, as usual, in the back of the report. To supplement those lists: Construction & Engineering rose onto the top four list for the first time this week while Computer Storage & Peripherals fell off; meanwhile, Retail-Drug and Motorcycle Manufacturers fell onto the worst-performing list this week while Retail-Food and Distillers and Vintners resurrected. (The groups moving out of each category are probably the most timely to look at.)

OUR FIDELITY SECTOR FUND relative strength work strengthened significantly this week as seven funds rose back above the money market rate of return. This brought the percentage of funds outperforming cash up to 38% from last week's 20%, and the rise above 33% was enough to generate a "buy signal". The positions in our switching program, meanwhile, are unchanged from a week ago: the #2 Telecommunications fund, #3 Software and #5 Multimedia. And the two highest-ranked funds this week are Gold and Telecommunications, while the two lowest-ranked funds are Medical Delivery and Electronics.

MAJOR OVERSEAS MARKETS. The German and U. K. markets have been moving pretty much in lockstep during the past couple of months; since the German market is the more volatile of the two, is probably has more recovery potential from a short- to intermediate-term basis (the next six months or so.) The Japanese market, though, may have even more potential than that; the Nikkei has been building a nice base in the 8300-9200 area despite being barraged with all sorts of bad news, and appears (like the NASDAQ) ready to stage some sort of longer-term recovery here. The Japanese stock market thus appears to be well-positioned here to rally from a longer-term standpoint, and we therefore think this is a good time to accumulate Japanese stocks. (We like the emerging markets even more, though, as noted in Our Own Money.)

Walter Deemer

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