The Coming Week: Ignoring the Market's Demon Heart

It might be Halloween month, but most players seemed content to leave the monster hunting for another day.
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There was a raucousness on Wall Street going into the weekend, a feeling that the week's solid rally -- backed by a steady gain in breadth -- had sunk a stake into October's demon heart. And while there was some worry that the demon might be a bit like Jason in

Friday the 13th

-- you know, like, dead, but not

really

dead -- most were comfortable with getting up, giving the monster a poke with a stick and blithely turning their backs.

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"I think we're heading immediately for a retest of the October high," said Peter Canelo, the

Morgan Stanley Dean Witter

investment strategist who has been so accurate in calling the markets ups and downs this year. "Break that, and you have to think we're going to attempt to go back to the highs."

Whether the market reaches toward its highs of the year or peters out -- shifting back into that up-and-down pattern that's gotten so familiar -- will greatly depend on investors getting a little clarity on some of the issues that have been bugging them lately.

The big worry remains the

Fed

. "I think they'll raise rates," said Canelo, who thinks the market's discounted a 25 basis-point hike. "But there's some concern that they'll go twice

or that they'll hike by 50 basis points. Or that they won't go at all. Figure that out."

All right, we're game.

The problem with a Fed that ends up hiking by 50 bps is that that's at least twice as much as the market expects right now. Bonds get knocked down another peg, that nice bottom that formed in financial stocks gets taken out.

Et cetera.

The problem with a Fed that doesn't move at all -- for some people at least -- is that that's a Fed that may end up way behind the curve on inflation. It's the kind of thing Steve Roach, the chief economist at Canelo's firm, worries a lot about. If the Fed has to play catch-up with inflation, it has to tighten a lot more than if it had it acted preemptively. And if that happens, the economy could decelerate too quickly -- sending the U.S. into its first recession in nine years.

The inflation worry isn't idle.

Merrill Lynch

chief quantitative strategist Rich Bernstein's

Inflation Composite Index

is an equal-weighted average of year-to-year change in eight common inflation barometers (the

Consumer Price Index

, gold, average hourly earnings, etc.) It troughed in August of last year and last month it turned positive for the first time since 1996.

The index can be used as a measure of where inflation is headed, but maybe more importantly it is a good measure of inflation

expectations

. Most investors look at least a couple of the index components when they try to get a read on whether things are heating up. The index's turn positive suggests that more investors might begin worrying about a behind-the-curve Fed.

For Bernstein, the important thing about the inflation index going positive is that it suggests companies will have better pricing power. Better pricing power tends to benefit the stock of companies that are tied to the earnings cycle -- rather than growth companies, whose big draw is that they grow steadily through the entire cycle. The Nifty Fifty is out, in Bernstein's book, and value stocks are in. With a rebound in global growth, Bernstein reckons that the best place to look for returns is cyclical stocks with heavy overseas exposure.

Besides a little clarity on the Fed, Morgan Stanley's Canelo thinks that investors will need to get a better sense of what's going on with Y2K.

IBM's

(IBM) - Get Report

disappointing earnings -- blamed in part on slower purchases ahead of the millennium change, has stirred worries that other techs may suffer. It's gotten a little confusing --

Microsoft

(MSFT) - Get Report

and

Oracle

(ORCL) - Get Report

say they haven't seen a Y2K slowing; IBM and

Lexmark

(LXK)

say they have. Canelo says that as more results get released next week -- and more companies testify on what sort of Y2K impact they're seeing -- the issue will see some sort of resolution.

Interestingly, Y2K issues may play a part in the big economic reports getting released in the coming week, according to Jim Glassman, U.S. economist at

Chase Securities

. The big reports will be third-quarter

gross domestic product

and the third-quarter

Employement Cost Index

, both out on Thursday. Both reports are expected to come in strong.

"People are going to be nervous about these numbers, but I don't think it's going to be as much of a clear-cut case for tightening as you might otherwise," he said. He believes that a lot of the strength in the third quarter has come from inventory building by companies who worry that Y2K glitches could make their just-in-time operations anything-but.

Said Glassman: "The market is betting that the Fed is going in November. I personally think that they're uncertain about how much of the strength in the economy is being driven by stock-piling."