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Fog of War Lifts, Revealing Grim Reality

The market, which staggered Wednesday, faces a potentially dangerous military occupation in Iraq and a weak economy here.

Vice President Cheney hailed "one of the most extraordinary military campaigns ever conducted," and British Prime Minister Tony Blair was reportedly "delighted" with Wednesday's remarkable footage from Baghdad. But Wall Street's reaction to the toppling of Saddam Hussein's regime and Iraqis waving American flags and cheering President Bush was far from euphoric.

On the surface, Wednesday's setback for the major averages seems bizarre, given that the major part of the military campaign in Iraq reached a successful conclusion far faster than many had expected just a few days ago. But the session reveals the logical side of Wall Street, even if it seems to be of the twisted variety to many.

First, let's recall that the "market will rally when we win the war" mantra has been repeated, ad nauseam, since months before the war actually started. Whenever something is so widely anticipated, what inevitably happens is that traders buy "in anticipation" of the event. Not surprisingly then, major averages hit their intraday peaks Wednesday in concert with footage of a large statue of Saddam Hussein being pulled down.

In hindsight, it seems pretty clear the rally from the March 12 lows embodied this anticipatory buying -- perhaps the rally from the October lows as well. As once source quipped, "We now are all free to wonder if the war is a 'sell-the-news' event."

After trading as high as 8388.33 at about 11 a.m. EST, the

Dow Jones Industrial Average

drifted steadily lower thereafter before downward momentum accelerated in the final hour. The Dow closed down 1.2% to 8197.94.

Following similar patterns, the

S&P 500

ended off 1.4% to 865.99 vs. its intraday high of 887.35, and the

Nasdaq Composite

slid 1.9% to 1356.74 after trading as high as 1393.40.

Second, market participants may now become more focused on the potentially difficult mop-up operations in Iraq and the

postwar aftermath.

"There are many dangerous areas of Baghdad for our armed forces that remain," White House spokesman Ari Fleischer said Wednesday. "There are many other cities in Iraq that are dangerous

and where armed conflict could result." Later, U.S. Marines came under fire at Baghdad University, and U.S. Defense Secretary Donald Rumsfeld warned that the fighting could continue for some time.

Meanwhile,

CNN

reported that another administration official cautioned against "irrational exuberance," a phrase that should resonate with investors.

On a related note, there's concern in some circles that the Bush administration, emboldened by its success in Iraq, will seek to expand its "pre-emptive doctrine." Notably, Rumsfeld chastised Syria for not heeding his earlier warnings about providing military assistance to Iraq and for providing a haven for senior Ba'ath officials. And of course, Iran is a charter member of Bush's "axis of evil."

Third, and more fundamentally, the rationale behind the war-equals-rally mentality was that "as those

geopolitical uncertainties lift, as most analysts expect, the accommodative stance of monetary policy, coupled with ongoing growth in productivity, will provide support to economic activity sufficient to engender an improving economic climate over time," to use the Federal Open Market Committee's verbiage. If it was good enough for Alan Greenspan & Co., it was good enough for Wall Street.

However, now that the main military campaign is ending, optimists can no longer hide behind the "war uncertainties" excuse and must face the somewhat grim economic reality.

Lost in the war shuffle but consistent with the market action, Blue Chip Economic Indicators said Wednesday that its April survey showed economists expect GDP growth of 2.4% in 2003, down from 2.6% in March's survey and 2.8% in January,

Bloomberg

reported. (There were no economic reports Wednesday, but Thursday brings jobless claims data and the increasingly important trade balance for February.)

Notably, crude futures rose 3% to $28.85 per barrel despite events in Iraq and following separate reports of falling crude inventories by both the Department of Energy and the American Petroleum Institute.

Partially in reaction to stocks' struggle and partially to prospects for weaker economic growth, the price of the 10-year Treasury rose 11/32 to 99 27/32, its yield falling to 3.90%. Gold futures rose 0.3% to $327.30.

On the corporate front,

Microsoft

(MSFT) - Get Report

fell 3.9% after Goldman Sachs' Rick Sherlund warned that the software giant will likely lower its 2004 earnings guidance.

Yahoo!

(YHOO)

fell 4.1% after J.P. Morgan initiated coverage with a neutral rating, ahead of the firm's earnings report due after the close. (After the close, Yahoo! posted better-than-expected first-quarter results and raised its guidance for the rest of 2003.)

TheStreet Recommends

Among other individual names,

Dun & Bradstreet

(DNB)

fell 12.3%,

Stanley Works

(SWK) - Get Report

lost 11.6%,

Borland Software

(BORL)

shed 7.2%, and

Phoenix Technologies

(PTEC)

slid 7.1%. Each warned of lower-than-expected results.

Conversely,

United Technologies

rose 0.5% after reaffirming its earnings guidance, and

NCR

(NCR) - Get Report

jumped 11% after forecasting a smaller-than-expected loss.

Fourth, the market's technical picture remains weak. Whether that is a cause or effect of the market's reaction to Wednesday's war news -- or totally coincidental -- does not change the fact that technically inclined traders will be more inclined to sell into rallies in the wake of

Monday's reversal.

Rick Berry, an independent technician, further observed that Wednesday's decline broke the Dow's uptrend line from its March lows. The last time that happened was on

Jan. 21, which marked the end of the uptrend from the October lows and presaged a swoon for major averages, Berry recalled. "Bottom line: Lower highs and lower bottoms

are bearish."

On the sentiment front, Chartcraft.com's

Investors Intelligence

survey showed that bullish sentiment rose to 51.1% vs. 47.2% on April 2, while bearish sentiment fell to 31.1% from 34.8%.

Elsewhere, the VIX rose 4.5% to 30.91, and the 1-day Arms Index jumped to 2.15 from 1.44, but the CBOE's put/call ratio fell to 0.73 from 0.80 Tuesday.

Perhaps the biggest thing working in the bulls' favor Wednesday was that trading volume was light, keeping with recent trends of lower volume on down days. In

Big Board

trading, fewer than 1.3 billion shares were exchanged vs. nearly 1.5 billion on Monday, while declining stocks led advancers 17 to 14.

Certainly, Wednesday's setback is likely to generate more skepticism -- especially among retail investors -- which often proves to be a contrarian signal, over time. Furthermore as the "sell-the-news" rationale for the action becomes more widespread and accepted, the possibility rises that such an explanation will prove faulty and the market will rally again.

If nothing else, Wednesday proved that incredible and amazing things are possible.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task