Barry Ritholtz
Bounce Beckons but Long-Term Challenges Remain
 By Barry Ritholtz
RealMoney.com Contributor

9/28/2004 2:39 PM EDT
URL: http://www.thestreet.com/p/rmoney/barryritholtz/10185083.html
 U.S. Economy
  • With or without further stimulus, the U.S. economy requires a simple prescription for healing: time.
  • We continue to look at the markets as presenting trading, but not necessarily investing, opportunities.
    		•

    Two weeks ago, the S&P 500 and Dow Jones Industrial Average had reached the top of their trading ranges and I surmised that, at the very least, a retracement of the Aug. 13 to Sept. 15 rally was likely. Furthermore, I suggested any break of S&P 1123 would project a pullback toward 1100-1105.

    These levels have been reached -- the S&P traded as low as 1101.29 Tuesday morning -- and the markets have become slightly oversold, at least on a short-term basis. That suggests to me that a small, relatively insignificant, bounce is due. After that, we should resume moving downward toward an intermediate-term low sometime in October.

    As that progression unfolds, investors may wish to ponder this philosophical query: What is the meaning of the lower highs and lower lows of 2004? Are we in a bear market? Or, as some have argued, are we merely digesting outsized gains from 2003?

    With the third quarter ending Thursday, and the indices flat to down for the year, one can hardly claim this is a powerful bull market. Yet the range-bound environment hardly proves the bear's case.

    My conclusion? We are working our way through a post-bubble, post-stimulus economy. We continue to suffer the hangover from the bubble's aftermath: The Nasdaq Composite remains more than 60% off from its all-time high. Capacity utilization is lingering in the 75% area, thanks to all the overbuilding and over-investment from the 1990s. End-user demand remains anemic, and manufacturers find themselves unable to pass along price increases, despite the rising prices of many commodities.

    All this suggests that economic growth will remain modest -- in the 2.75% to 3.5% range. Inflation will be found primarily in commodities, as opposed to the typical economic expansion where wage pressures predominate the inflation chatter. Job growth will continue to be mostly mediocre. Investors should expect sub-par returns from the indices as they revert to their historical mean.

    With or without further stimulus, the U.S. economy requires a simple prescription for healing: time. That's what it takes to repair and to work off the excesses of the bubble. One cannot will demand into existence, nor can one create it out of thin air via stimulus or supply-side tax cuts. End demand is a function of the business cycle, and government intervention -- no matter how well intentioned -- is unlikely to substitute for the salve of time.

    How much time? After Japan's bubble popped in the late 1980s and a subsequent drop of the Nikkei Dow by some 80%, the Japanese economy was hung over for a decade and a half. The Japanese central bankers, however, made the mistake of cutting rates rather gradually. They allowed a deflationary mentality -- postponing purchases as prices slid -- to take hold amongst their consumers.

    Thankfully, that hasn't happened in the U.S. Our central bankers produced far more monetary stimulus, and in a faster time frame, than did their peers across the Pacific. We also appear to have dodged the deflation bullet (at least so far). But that doesn't suggest that we are out from under the post-bubble environment.

    As such, we continue to look at the markets as presenting trading, but not necessarily investing, opportunities.

    That leads me to look at a shorter time frame than usual.

    Modest support exists at S&P 1100 to 1105; if we get extreme sentiment readings at that level, we would be buyers, albeit with tight stop-loss points. However, I expect that the more likely scenario is that the bounce off of those levels will fade until we see a more compelling bottoming process. Why? Several of my indicators are saying that this is merely a mildly oversold condition, but one lacking in significant support or sentiment extremes.

    Here's one of my favorites: the percentage of Nasdaq issues that are on a MACD buy signal. As this percentage drops below 50% -- as it has three prior times in 2004 -- it suggests that near-term Nasdaq momentum has peaked and is reversing. Each time this has occurred in 2004, in early January, mid-April and early July, the markets have fallen fairly significantly 30 to 60 days out (by 8.6%, 8.2% and 10.9%, respectively).

    Click here for larger image.

    Of course, past performance is no guarantee of future returns. Still, traders should be cognizant that Nasdaq MACD buy readings below 50% have typically been a harbinger of additional weakness. In some instances, there have been minor bounces before the continued move down.

    Longer term, I expect this next bottom to be the last of 2004, especially if it is made as sentiment reaches extreme levels. That sets up a rally into year's end, and possibly deeper into the first quarter of 2005.

    From there, we move into uncharted and dangerous territory. A number of potentially negative variables are on my radar screen and bear watching closely:

  • Oil could continue rallying -- my price target is $57;
  • the economy may fade further with less and less stimulus;
  • the Iraq situation may go from bad to worse, and;
  • commodity prices could continue to rally, squeezing margins.

    • None of these are definite, of course, but they are worth watching.
    Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to barry.ritholtz@thestreet.com.