What's in Store for the Rest of 2004

Moving to this week, we started with a strong rally on moderate volume. Despite oil powering higher, the markets focused on the opening of the Olympics instead. Security was tight, and the opening ceremonies and subsequent competition went off without incident. Additionally, the economic news improved, supporting Federal Reserve Chairman Alan Greenspan's view that the past few months have merely been a soft patch that's typical at this stage of an economic expansion.

Considering this recent action -- including Monday's rally and the subsequent follow-through on Tuesday and Wednesday -- what can we expect for the rest of the year? As of right now, I see three possible scenarios playing out as the markets move toward 2005.

Scenario 1: Waterfall declines leading to a much lower low. This is the worst-case possibility. I also think it's the least likely of the three. Internals have been relatively good -- not spectacular, but decent. Market breadth, despite the serious correction since the January highs, reveals accumulation actually continuing by large institutions. Mutual funds are sitting with large amounts of cash as opposed to being overinvested, as they were in 2000.

A/D Divergence Index

Source: Chart courtesy of Jim Stack of InvesTech Research (http://investech.com)

As Jim Stack says (see his chart above), "market breadth measures participation, and broad participation breeds bull markets."

This is not the sort of environment that typically sets up a catastrophic selloff -- at least not without some external factors pressuring the markets. What factors? Oil rising to $60 a barrel, a major assassination, a significant terrorist event, etc. Any of these externalities could cause a major dislocation. As Gary B. Smith has shown, these tend to be temporary.

Scenario 2: A rally for the rest of the year. In order for last week's lows to be the bottom for 2004, several factors must converge at once: First and foremost, volume needs to come back into the market, and in a big way. Volume is a measure of conviction, and weak volume indicates a lack of conviction. Stocks rallying on light volume merely suggests that the sellers are on vacation. This is not the same as indicating a major new round of accumulation by large institutional players.

What else might help? A decline in crude oil prices by $5 per barrel sometime soon would be a start. Even a brief retracement could help. Oil anywhere in the low $40s would be a huge psychological boost. Once the commodity starts trending lower, it may even develop some downside momentum.

For Scenario 2 to play out, we also need to see some economic reports to show signs of strengthening -- or at least to stop decaying. Some of the recent data points have been decent: Producer prices seem to be moderating, consumers are still spending, and housing starts and refinancings remain a bright spot.

I'd be encouraged if the markets have a follow-through day in the style of a William O'Neil confirmation day: a rally of 1% or better on higher volume than the previous 30-day average, on the fourth to ninth day after the initial move up. That's somewhere between today and next Thursday, Aug. 26. A confirmation day would show that Monday's rally was not merely a one-day wonder.

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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. 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 [e-mail].

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