Taking Stock as the Traders Head for the Dunes

Concerns linger that the bonds could spoil hopes for a quiet pre-Memorial Day week.
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Earnings season done with. No economic news to speak of. Merger activity dying down. Fund managers sitting on good gains and staring out the window.

Wall Street didn't have a summer last year -- the troubles with Russia and Brazil and

Long Term Capital Management

intervened -- and lately it's looked as though it's trying to slip into those slow and easy rhythms a bit earlier than usual. Stocks have been drifting lower in light volume -- just the sort of thing you see when the buyers head to the beach. Bonds look like they've found their feet. In the coming week, the biggest hurdle the market will face may well be its own lethargy.

Let's hope so. The problem with quiet markets is that people start to think about the horrible things that could happen. Prophecies, when widely held, tend to be self-fulfilling on Wall Street, and furtive glances toward the exits become stampedes. "With Memorial Day coming up, we've got the perfect setup for a quiet week," said Joel Kent, economist at

Lehman Brothers Government Securities

. "But every time the market gets quiet, something exogenous seems to come up."

Kent was talking about the Treasury market, but he might as well have been talking about equities, too, because if the stock market

does

run into any trouble over the next few weeks, it will probably come at the hands of the bonds. "Right now, rates are pulling back," said Byron Wien, chief investment strategist at

Morgan Stanley Dean Witter

. "But if the long bond goes to 6%, then the stock market's in trouble."

Unfortunately for stocks, the upside for the bond market seems pretty limited on the back of the

Federal Open Market Committee's

move last Tuesday to a tightening bias. "The market's sort of caught in an iron, as they say in sailing," said Wien. "It can't really make much forward progress. Valuations are extreme. News on the economy can't get any better. Stocks are fully priced. So the market is just marking time."

But short of another surge in rates, says

Everen Securities

chief technical analyst Greg Nie, the downside for stocks looks pretty limited. Volume over the past week, as the major indices trended lower, was incredibly light -- an amazing thing considering the Fed's change in bias and the options expiration on Friday. "That clearly paints the pullback as an interim one," said Nie, "with no momentum behind it. I would look for a relatively quiet week going into the holiday."

Yet just because the major indices we like to call "the market" don't look like they'll be doing all that much, the stocks that lie under the surface, the small- and mid-caps, might do well nonetheless. Dissatisfied by the recent performance in the big-cap tech and Internet stocks that they were weaned on, it looks like a lot of individual investors are, in good

Peter Lynch

fashion, kicking the tires on downtrodden issues and taking them out for a spin. And Ed Nicoski, chief investment strategist at

U.S. Bancorp Piper Jaffray

, points out that small- and mid-cap fund managers had loaded up the boat on as much big-cap growth as their charters would allow.

If the move in small- and mid-caps holds, it has been a damn long time coming. Since 1995, the

S&P 600 Smallcap Index

has underperformed the

S&P 500

by more than 100 points. "You should recognize that over long periods of time, small-cap does not lag

behind big-cap," says Hugh Johnson, chief investment officer at

First Albany

. "Sooner or later, there is a symmetric catching up. If there is, we're going to be talking about small-cap and mid-cap growth for the next 12 months."

It is important to remember that the thing that can kill the small- and mid-caps in their tracks is rising rates. These are generally not companies with huge global presences, so their results are much more dependent on growth in the U.S. economy. And more than their bigger brethren, they often need outside capital to grow. When interest rates go up, so does the cost of capital. Small- and mid-caps have been making great progress lately, but whether they can keep it up will depend greatly on whether Uncle Al holds back from tightening the taps.