The following commentary was posted at Gillespie Research

Summary

The stock market is at or very close to an important inflection point. Will the result be an upside or downside move in prices over the next week or two? I believe the odds favor the negative outcome, and in this regard, yesterday's performance was not a great portent for the bullish camp.

The Interest-Rate Backdrop

The stock market kicked off this week on a sour note, and interest-rate developments had a lot to do with it. The secular bull market in bonds ended on 6/13/03, when the Greenspan deflation "ruse" (my opinion) led to the final spike in prices, trough in yields. It was a Friday the 13th to boot! Therefore, 6/13/03 dates the beginning of what so far has been a cyclical bear market for bonds.

The trend in rates has been irregularly higher since then, with the 2004 increase in yields accelerating in recent weeks, particularly at the short end of the Treasury curve. The rise in this sector has reflected the changing perceptions about what the Federal Reserve will have to do this year in reining in what has been an exceptionally accommodative monetary policy.

Here's a look at what's happened over the last three weeks and from last June's trough levels. (May 28th marks the recent end-of-week low in yields. See Table 1 at the end of the text for additional data.)

During 2004 to date, the course of interest rates has conformed closely to our negative forecast of months ago. It was predicated heavily on the conviction that inflation would accelerate, forcing the Federal Reserve to raise rates sooner than what had become the overwhelming consensus view. Not all that long ago, there were some in the Wall Street analytical community opining the Fed would not hike rates at all during 2004.

Since the Federal Open Market Committee's last meeting, held on 5/4, there has been a sharp rise in federal funds futures. The July contract ended yesterday at 1.33%, up 22 basis points from its 5/3 close. The December contract closed at 2.44%, up 61 basis points from where it stood on 5/3. (See Table 2.)

There is now thought in some quarters the FOMC will raise the fed funds rate a half point at its June meeting, scheduled for 6/29-6/30. The longer end of the Treasury curve would find the Fed's effort to get less behind the curve consoling. On the other hand, stock investors, who have been increasingly seduced back into the market over the last year by Greenspan's "cash is trash" cabal, would likely find a half-point hike less to their liking.

Changing interest-rate expectations in recent months have paralleled changing inflation expectations. And here, we will take credit for having seen this coming a good deal earlier than many if not most others in the forecasting fraternity. We've kept close track of this in our "Inflation Watch" table, currently appearing in a graphical format on the website. Oddly enough, we mostly used the same government data others were heralding as "proof" there was no inflation problem. We came to quite a different conclusion, however!

The chart is due for some revisions. Recent import-price data covering May showed prices in this area up 7.0% year over year, and up at an annual rate of 10.9% over the trailing three months. The Labor Department will report on May consumer prices today. As to producer prices, which were due out last week, the Bureau of Labor Statistics raised suspicions in some circles last week with the following announcement:

"The Producer Price Index (PPI) for May 2004, originally scheduled for release on June 11, has been postponed until further notice. BLS staff are working to resolve the unexpected difficulties in calculating the index this month. A revised release date has not yet been set but could be no earlier than Tuesday, June 15. When a revised release date for the May 2004 PPI has been determined, it will be announced at least one day ahead of time on this web page and through a news advisory. The BLS expresses its apologies to those who experience any problems as a result of this delay."

The Stock Market: A Failing Rally in Progress?

Earlier this year, part of the scenario I laid out in discussing the important topping and rolling over process I thought 2004 would see was a test of 200-day moving averages by the important bellwether measures. This came to pass during the May lows, and a good upside bounce has occurred since. For the three trading weeks ended 6/11, respective DJIA, S&P 500 and NASDAQ 100 gains were 4.4%, 3.8% and 5.2%.

So, is the "healthy correction" over? (Are there any other kinds of market declines according to CNBC and the other venues in the regular propaganda loop?) The current week could provide an important piece in the overall puzzle.

As of last week's close, the seven measures comprising my stock-market tracking group stood, on average, 3.5% below respective 2004 closing highs. Here's what the situation looked like.

Yesterday's rather dour performance saw the group decline an average 1.3%, done on light volume but on genuinely horrible NYSE breadth measures. So this important week kicked off in not-such-good fashion. However, don't forget what this week is. It is an expiration week, containing both options and futures legs. These are the 12 times a year when the Wall Street and LaSalle Street axis powers often team up to work some interesting market "magic" (euphemism for something a bit more nefarious). Therefore, because the week started off poorly certainly does not mean all is lost for the bullish cause.

The big-picture message is this. The equity market is at or very close to what retrospectively will have been a critical inflection point. From a technical perspective, the market entered this week in a meaningfully short-term overbought condition. (See Table 3.)

The market's overbought condition would argue for a correction from around current levels, so yesterday's pullback was an event falling into something you might term an "expected outcome." Nevertheless, I suspect Wall Street came into the week with long positions larger than desired. I also think many of thousands of hedge funds that now exist have long stock positions they want to pare, as the unwinding of the "carry trade" continues.

If the above assumptions are about on target, what we're talking about is an attempt at further distribution of long positions to the proverbial "public," which, in past months, has renewed its old-fashioned tenacity to buy dips. In somewhat less polite terms, you can also call it an attempted setup, in which the public becomes the "bagee." And part of the methodology for pulling off the caper would call for a try at using this week's expiration to paint charts.

But maybe exogenous forces -- interest rates, primarily -- don't cooperate, and the stock market falters, then pulls back, from around current levels, or even ones a bit higher. Then what you have is something that looks an awful lot like another installment in the unfolding 2004 saga of "failing rallies." Invoking Martha parlance, "this would not be a good thing," not if you are a bull and fully invested in stocks.

There's no question we are at a dicey juncture. But being a forecaster means making forecasts, doesn't it? And my best judgment at the moment leads me to conclude that stocks will not punch through to the promised land. Instead, I think we are near an important fail that will segue into a period during the remainder of June and, on balcne, through most of July, that is not very pleasant.

What is a realistic downside objective? Well we live with markets that are exceptionally leveraged, leaving them ever vulnerable to accidents. In the absence of one of these, I would think the bellwether averages will be heading for another test of 200-day moving averages, with a good chance that before the coming leg plays out, respective 200-day averages will be breached rather materially.

The following table lays out some targets, based on last week's closing prices.

Table Appendix