With allied forces facing a potentially difficult fight ahead in Baghdad and another round of data showing a sickly economy, market participants restrained the euphoria that was evident

Wednesday. But the recent tide of rising optimism remained mainly intact Thursday, as major averages suffered only modest losses.

While allied forces are close to Baghdad and in reach of capturing Saddam Airport, U.S. military officials continue to speak cautiously. Brigadier General Vincent Brooks told reporters in Qatar "there are still options open to the regime, including the use of weapons of mass destruction," And Defense Secretary Donald Rumsfeld warned "the toughest fighting may yet lie ahead."

And there are other sobering situations in Iraq and elsewhere: the possible loss of aircraft to friendly fire, reports from NBC news about the discovery of American dead at the POW rescue site, continued reports of Syrian arms shipments, still-escalating tensions out of North Korea, and even news of the spreading SARS epidemic.

By ratcheting down their enthusiasm, traders acknowledged that the toughest fighting may indeed lie ahead and that the

postwar aftermath could more difficult still. While the overall military picture is positive, these side issues remain troubling. Combined with Thursday's weak economic news (and the fact that Friday's could be worse), the only surprise is that the markets didn't sink lower.

On the home front, the government reported that weekly jobless claims rose to a higher-than-expected 445,000 for the week of March 29, the largest weekly rise since December. The latest spike brought the four-week moving average to 426,000. Separately, the Institute for Supply Management's non-manufacturing index fell to 47.9 in March vs. 53.9 in February, indicating contraction in the services sector and its lowest level since October 2001. Expectations were for a more modest drop to 52.5.

Many economists downplayed the significance of the ISM data, noting that severe weather conditions and the buildup to war restrained economic activity in February and March. Still, given the recent weakness in the ISM's manufacturing report on Tuesday and other recent data points, the U.S. economy definitely appears to be backtracking.

"The fact that the coalition forces have cut the distance from Baghdad by 50% in 24 hours is outweighing the string of despondent economic reports in the U.S.," observed Ashraf Laidi, chief currency analyst at MG Financial Group.

Laidi spoke early in the session when the greenback, which ultimately maintained its advance vs. the euro and yen, and shares were both higher despite the aforementioned data.

Some of the late-day weakness in equities could be attributed to traders looking ahead to Friday's employment report for March. The report could mark a turning point in terms of whether economic news can (finally) trump war developments.

Major averages had spent most of the day in modestly positive territory but retreated notably in the final 90 minutes. The

Dow Jones Industrial Average

ended off 0.5% to 8240.38 vs. its intraday best of 8335.62. The

S&P 500

slid 0.5% to 876.45 and off its high of 885.89, while the

Nasdaq Composite

ended fractionally lower at 1396.58 vs. its best of 1412.10.

The Comp's outperformance was credited to

Dell's

(DELL) - Get Report

reaffirmation of earnings guidance late Wednesday. In general, first-quarter warnings to date by tech firms have not been as widespread as feared, although

Cerner

(CERN) - Get Report

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tumbled 45% after the health care information technology provider waved the red flag. (After the bell Thursday,

PeopleSoft

(PSFT)

,

Sybase

(SY) - Get Report

and

WebMethods

(WEBM)

were among the firms to warn.)

At 1.3 billion shares on the

Big Board

and 1.1 billion over the counter, trading volume was down from Wednesday's levels, continuing a recent trend of higher volume on up days vs. down. That's the good news for those with a bullish slant. The bad or potentially unsettling news is that the S&P failed to sustain an intraday move above its (down-sloping) 200-day moving average of 885.54. (The Comp remains above its 200-day moving average, currently 1339.73, which it surpassed in mid-March. The Dow is still a bit below its comparable level of 8376.65.)

"The 200-day moving average is really considered the borderline between bull and bear markets," said Bert Dohmen, president of Dohmen Capital and editor of

The Wellington Letter

. "We were up there" but failed.

Dohmen observed that "everybody seems to be waiting for a positive event so they can jump in with both feet and buy." Thus, he believes the Dow and S&P will likely eclipse their 200-day moving averages on a "victory rally." (VI-Day?)

But "whatever rally materializes" after our presumptive triumph in Iraq, "I think that'll be about it," said the veteran

market timer, who noted that sentiment remains far more bullish than at any prior major market bottom.

Observing low cash holdings at mutual funds and "many big funds proudly saying they're fully invested," Dohmen wondered where the firepower will come from for (much) further upside. Noting steady redemptions from equity funds this year and the public's growing distaste for Wall Street, he surmised "there's so much less money for the stock market vs. in 1999" and believes that "shrinking process" will continue over the next decade.

Furthermore, "there's a lot of bad stuff to come out," he said, suggesting "the economy is in terrible shape and earnings are not going to come through." After a few more months of bad economic news, traders will say "'if it's because of war or snow or people from Mars, it doesn't matter,'" Dohmen added.

The newsletter writer maintains that stocks will "drift down" until next fall, the potential for any short-lived, war-related rally notwithstanding.

Too much bullishness, a bad economy, overhead resistance, valuations (which Dohmen also mentioned) and a disenchanted public in a post-bubble world pretty much sums up the bearish view. The skeptics had been backtracking this week until Thursday's session. But even then, they weren't able to put much of a dent in the market's recently bullish tone.

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.