EDITOR'S NOTE:

Before we dive into the thick of our work we have to comment on the events of this weekend. Of course Saddam Hussein was captured. Probably good news for humanists the world over, and not something to be reduced in scope or meaning by measuring the event in terms of the market's reaction to it. However, market reactions are the business at hand, so I have to do my best, but with this apology for having to do so.

As I assemble my work this Sunday evening I see that the S&P futures are up about 14 points and the Nasdaq 100 futures are up about 26 points.

I have to be honest and tell you that I have no methodology for predicting how strongly the market will react to what looks like it will be an opening gap up in the cash indices tomorrow morning. Just how much the events of the weekend mean to the morale of our country and to investor sentiment is something of a wildcard in my mind, though it sure looks like a positive. Given the work in the SEASONAL section below (we're headed into the strongest weeks of the year) it would be surprising if we did not see some follow-through to the upside. More below...

--AO

Weekly Economic News Diffusion Index (WENDI)

WENDI weakened considerably this past week. The flow of economic news was positive, but much less so than it had been for the prior month-and-a-half. Wholesale Trade and Business Inventories were the only unqualifiedly bullish data points while International Trade was clearly bearish. Some weekly retail numbers were hit by the stormy weather in the Northeast, Mortgage Applications declined, and the consumer shows some signs of wearying. Meanwhile a couple of minor manufacturing surveys backed off from recent strength without going negative.

On an average number of components (13) the Weekly WENDI dropped down from 50% to 15%. The 4-Week Weighted Moving Average dropped 7 points to 49% and the Cumulative WENDI rose a modest 2 points to 49. The last two weeks have shown deceleration within a positive trend. And that's probably a good way to sum it up.

If you can't sleep after a weekend of watching football, here are the individual WENDI components:

1. KC Fed Manufacturing Survey: The headline number for November dropped from 28 to 6 (ZERO is neutral). Following on 3 extremely strong months this reading represents slowing upward momentum, not a decline. Employment picked up and New Orders remained robust at 14. Volume of Shipments and Prices Received dropped a hair. Qualified Bullish (0.5).
2. BT-M Chain Store Sales Snapshot. Dropped 2.5% for the week, the largest weekly drop in 3 years. However that drop was significantly attributable to the snowstorm in the Northeast. Y/Y sales were still up a solid 4.9%. BT-M lowered its projection for the month from the 3.5-4.5% range from the 4.0-4.5% range. Anecdotal reports suggest that the sales drop on Saturday was significantly made up on Sunday. We have to go "negative" on this, but we'll qualify it because of the weather and the strong Y/Y growth. Qualified Bearish (-0.5)
3. Richmond Manufacturing Survey: Headline number dropped from 20 to 11 for November. However New Orders picked up from 6 to 14. Backlog of Orders increased as did the 6-Month Outlook. The Employment Index fell. Qualified Bullish. (0.5)
4. Wholesale Trade: For October sales grew more than expected at 2%. Inventories also rose more than anticipated at 0.5%. The Inventory/Sales Ratio fell to an all-time low of 1.18. Demand is picking up. Inventories are doing likewise but not fast enough to meet demand. Production will have to rise to catch up. All to the good. Bullish (1).
5. MBA Mortgage Applications Survey: The index dropped by 12%. It may be falling out of the "flat" in which it has been bound since late summer. The overall level is still solid, but if applications drop too much that will be a net drag on the strong housing sector. We cold call this neutral, but with the chart threatening to break down out of its recent range, I believe it's a Qualified Bearish (-0.5)
6. ABC News/Money Mag Consumer Comfort Index: Was flat for Dec. 7 at -11. This is a pause in a recent uptrend that broke above the key -15 level. The state of Personal Finances was deemed slightly worse than the previous week, though still above neutral. On the other hand the share of people who believe the economy is getting worse dropped by 4%. Neutral. (0).
7. Jobless Claims: Initial claims rose by 13K for Dec. 6 to 378K. Continuing Claims rose by 11K. Despite the weekly rise both series are in constructive downtrends. So, with a weekly rise within a downtrend we gotta go with Neutral (0).
8. Import/Export Prices: The rise in import prices for November was greater than expected at 0.4%. It was driven by a rise in demand for crude materials and other "production" inputs. This supports the rise in Industrial Production. Export Prices rose as well, driven by a sharp increase in beef prices. Qualified Bullish (0.5).
9. Retail Sales rose 0.9% in November, more than expected. Ex Autos Ex Gas (Core) sales rose 0.3%, which is less impressive. However October's numbers were generally revised higher. Core Sales are up more than 6% Y/Y. I think you could argue that this is a Bullish picture, but slowing core growth (on account of the REFI boom and tax rebates petering out) qualifies it in my mind. Qualified Bullish (0.5).
10. Business Inventories. For October sales increased more than expected, rising 0.7% while inventories gained 0.4%. The Inventory/Sales Ratio fell to a new all-time low. All to the good. Bullish (1).
11. Producer Price Index (PPI): For November fell at a 0.3% rate. Core prices fell by a modest 0.1%. Demand is picking up (as are prices) early in the production chain, but finished goods prices are generally in a very modest uptrend, with this month dipping slightly into the negative. Generally inflation is tame while the threat of broad-based deflation seems to be receding. The rise in the costs of crude goods shows that demand continues to improve. Qualified Bullish (0.5)
12. International Trade: The US Trade Deficit increased in October to $41.8B. Both imports and exports rose. The fact that demand is strong both from US and foreign buyers somewhat mollifies the negative implications of the large deficit, but this figure is still solidly negative Bearish (-1)
13. U of M Consumer Sentiment Survey: Fell to 89.6 for December's preliminary number, well below the expected reading of about 95.5. The combination of slightly-rising Initial Jobless Claims and the bad weather, which weighed on holiday shopping demand, may have affected the Current Conditions reading. Also, the consumer's cash flow and balance sheet may be suffering. The REFI boom is behind us, as is the '03 tax rebate. What qualifies our bearishness this week is that the stock market historically is able to make progress with this survey at 90 or higher. If it dips further next month, that will push us to a solidly bearish interpretation. Qualified Bearish (-.5).

Earnings

For the SPX the Consensus Forward 52-Weeks Operating EPS Estimate (blue) now stands at $61.18 up at a 15.31% annualized rate over the past 3 months and just $1.74 below its all-time high. While the growth rate of this figure probably peaked near 20% in October, it is likely to hold stead in the 12-15% range for a "considerable period." The PE on the blue line is 17.6

Trailing 52-Week Operating EPS (yellow) are now at $ 53.68, on a bullet. The PE on the yellow line is 20.

Trailing Reported EPS (magenta) are now at $38.74. However in the most recent quarter Reported EPS were $12.60 (a run rate of $50.40). The PE on the magenta line is 27.7. However the PE on the current run rate of the magenta line is 21.3. On April 1, '04 the magenta line will start reflecting the current run rate much more closely.

Looking Ahead at Valuation

Please recall how we have been defining Risk Premium in this space: how much the yield on the 10-yr Treasury Note would have to rise (fall) in order to match it with the consensus F52W Operating Earnings yield on the SPX.

Let's suppose that the current estimates for earnings for the SPX in CY04 turn out to be correct ($61.63). Further let's suppose that at the end of CY04 F52W EPS estimates are for an 8% rise (a very modest assumption and down from the current growth projection of 14%), which would take the figure to $66.42.

Now, let's suppose that the yield on the 10-yr Treasury Note rises to 5% (up by about 75 basis points from the current level).

To derive the Fed Model's fair value figure for the SPX a year hence we would divide that F52W EPS estimate by the yield on the 10-yr Note (5%). 66.42/0.05 =1328. With these inputs Fair Value a year hence will be about 24% above the current price.

If perceived risk remains high and the market continues to want to keep the Risk Premium at an elevated level (near 1.5%), then we would have to use 6.5% (0.065) as the divisor in the Fair Value equation. 66.42/0.065 =1021. That's 5% below the current level.

Of course any of these variables could fall outside the levels mentioned. Earnings growth could be more or less than our inputs. Interest rates could rise more or less than we suggest, and Risk Premium, as we've been defining it in this space, could rocket higher again or could drop to more historically normal levels (over the past 43 years) between -1% and +1%.

Using the inputs we've discussed here, the range of "outputs" (targets) is between 1021 and 1328 for the SPX. That's not very helpful, is it. Except that, as long as the inputs remain in the ranges we've discussed, it gives us a bullish bias for the next year. Of course as forecasts and hard numbers develop we will continue to update

Interestingly, if we split the difference between these two target extremes, we get 1174, very near to our next important technical target, as discussed below, of 1187.

A Look Down the Market's Throat

In our first bank of 8 charts we see that all our short-term momentum oscillators are pointing higher on recent buy signals.

The SPX has broke above the blue band (over 1060), hit its head on 1070 a few times, and is now headed higher. That's a confirmed breakout over the blue band and projects a short-term target of about 1090. (Looks like we'll open very near there on Monday.) The DJ-30 has also confirmed its breakout over its blue zone and looks like it will run higher on the break of 10K. The OEX has a textbook breakout over the 522-23 area. The Dow Transports (DJ-20) has been in danger of forming a Head & Shoulders Top. However a close above 2985 will kill that H&S as what would have been the Right Shoulder (RS) would be a new high...and a right shoulder (by definition) cannot be higher than the head.

The S&P MidCap 400 (MID--X) is in an intact uptrend. The Russell 2000 (RUT--X) is also in an uptrend but one that is weakening. A break down out of the blue zone again would be quite bearish and this index could end up forming an H&S Top as well. The SmallCaps are probably losing their leadership roll. If the LargeCaps don't pick up the slack in a big way, that's potentially bad news for the market.

Both the Advance/Decline Line and the Cumulative Volume Line shaping up bullishly. Interestingly, though, the A/D line is stronger (representing breadth) despite the fact that the SmallCaps are weakening. It appears that the renewed vigor in the Large and MidCaps is picking up the slack. Let's be aware of a possible weakening in the Cum Vol Line, though, as a possible sign that all is not well.

The following chart of our higher-beta and Tech-heavy indices show some marked relative weakness.

Both the COMP and the NDX are solidly within horizontal congestion. The SOX has broken its uptrend line and rallied back only up to its broken trendline. The NY High Beta Index (NHB) is back up into its broken wedge, but remains in its blue zone. The NDX A/D Line is back down into its blue zone after popping up in to the lavender zone.

All these charts have flattened out and are showing poor relative strength. Are they merely taking a breather before resuming the leadership rolls they took last March? Or are we looking at the first signs of an exhausted market?

Let's see how the market reacts to this "Saddam Gets Caught" rally. The following chart of the COMP's relative strength will be a key going forward.

In the lower pan the jagged blue line is derived by dividing the COMP's price by the SPX's. When it's rising the COMP is stronger than the SPX. When it's falling the COMP is weaker. As you can see the COMP's Relative Strength line (RS) is forming a rounded top. It has broken its 20-dma and its 50-dma and is testing horizontal support.

The broad market is generally much more bullish when that blue line is in a constructive formation than when it's declining or threatening to do so. Again, let's see if the COMP can resume leadership. We'll watch for it this week.

SPX

This chart of the SPX illustrates why we've been watching the 1070 area so closely.

Leg 1 of the rally carried the SPX up to about 1015. The index then retraced down toward 960 in Leg 2.

Now there are a couple of ways to measure targets from there. The short-term method is to add the depth of Leg 2 to the high of Leg 1 and the sum gives you the short-term target, or the height of Leg 3ST (if it breaks out). In this case 1015 + (1015-960) =1070.

The next method we use is called the Measured Move. Using this method we take the height of Leg 1 and add it to the low of Leg 2 to derive our Measured Move target for Leg 3LT. In this case: (1015-788) + 960 =1187.

If indeed we're headed up toward 1187, let's look for intermediate-term resistance near 1142 (62% of the way from 1070 to 1187).

On a much longer-term note, and in line with our valuation discussion above: IF we're headed into a major second leg of a bull market in which Leg 3LT would be 1.62 times as high as Leg 1 then our Leg 3LT target would extend to 1325, just 3 points below the Fair Value calculation discussed above.

On a cautionary note, if the market cannot hold on to the lion's share of its gains tomorrow, that would be extremely negative for the near-term direction.

Seasonality

The Santa Claus rally has a strong statistical tendency to begin on December 16. This year it may have begun a few days early and the Saddam Gets Caught effect will very likely obliterate the tendency for the 15th to be a down day.

On a seasonal basis from here it's a straight shot up through to year-end. In our study of SPX data back to 1962 we found that the SPX rises 83% of the time in the last 2 weeks of the year. That strength tends to carry through to January 6. The index is then choppy-to-up until the last week of January. From Jan. 27-Feb 7 tends to be strong...then a dip...and then a little pop into Valentine's Day. The 2nd half of February then tends to weaken, though not necessarily aggressively. (February 29, when there is one, has a strong positive bias, but there are only 7 of those dates in our study, and we don't have one this year, so we can probably ignore that little button-hook at the right side of the chart.)

Bottom Line

SHORT-TERM: Looking for strength through January 6.

MID-TERM: As long as the SPX holds above 1070 we're looking for 1142 and then 1187.

LONG-TERM: After hitting higher targets this winter, would expect tests down possibly as low as 1070 either later in 1Q or in 2Q04, as markets are generally disinclined to go straight up.

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Best regards and good trading!