The Great Retest Debate Rages On

Experts are divided about whether the major averages will approach their spring lows.
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After trying and failing to drum up a summer rally in the past few months, the major indices have slumped to their lowest levels since the middle of April, bringing the word

retest bubbling back to pros' lips.

Some bet the two-year lows the major market indices hit this spring were the worst Wall Street will see. But others speculate the averages will retest and possibly bust through those lows before the end of September.

After giving up 19% of its value over the past 12 weeks, the

Nasdaq is 14% above its two-year low of 1639 hit on April 4. The

S&P 500 has fallen 11% over the same period, putting it 5% above its two-year low of 1103.25, also hit on April 4. The

Dow, meanwhile, has dropped 10% since mid-May, and is 9% above its own two-year low of 9389.48 set in late March. On Friday, both the Nasdaq and the S&P closed at four-month lows.

Technicians and strategists think the Nasdaq, which is loaded with technology issues, is more likely to retest its recent lows than the blue-chip averages.

"The underpinnings of the Dow and the S&P 500 are probably strong enough to suggest that you're not going to go back to the lows," said Walter Murphy, technical analyst at Merrill Lynch. "The Nasdaq is in more dangerous territory relative to the retest," he added. Nonetheless, Murphy expects the Nasdaq to find support at 1800.

Philip Roth, chief technical analyst at Morgan Stanley Dean Witter, feels otherwise. "Tech, biotech, telecom, the speculative stocks, could make new lows," he said. "And the fundamental reason is that they're expensive."

Stocks do have a few positives on their side. Experts are looking for the

Fed

to cut interest rates a seventh time this year to 3.5% from 3.75% Tuesday. Rebate checks, totaling $38 billion, are making their way into shoppers' pockets, which could keep consumer spending strong, boosting the overall economy. And some recent data show the worm may have turned for the nontech economy.

But the tech sector is still in pretty bad shape. While a lot of bad news has already been "priced into" tech stocks, some worry that expectations and valuations remain too high.

"The bullish story is that a 75% or 80% decline discounts a lot of bad news," said Roth. "But I don't give much credence to that, because we had a bubble in technology, which takes years to work off."

Those who expect a retest think Wall Street will at least wait until after the

Federal Reserve's meeting Tuesday, and possibly until third-quarter earnings confession season, which begins around the second week of September. August is typically a very slow month, and there simply aren't many investors around to buy or sell stocks, or catalysts to move the market.

In any case, we've compiled a few arguments in favor of a retest, and a few assertions against that scenario:

The Doomsayers

1. Still No Light at End of Earnings Tunnel

Hopes of an end-of-the-year recovery in earnings were squashed this month when fourth-quarter earnings estimates slipped into negative territory for the first time. The first and second quarters saw huge drops in earnings, while third-quarter earnings are expected to decline 13.2% and fourth-quarter numbers are seen falling 0.4%, according to Thomson Financial/First Call. If the prophecies for fourth quarter are fulfilled, corporate America will have lived through four consecutive quarters of declining earnings by the end of this year, something that has never happened without the country falling into recession.

Technology has felt the brunt of the earnings blow. Analysts are now expecting the S&P 500 technology sector to record a 65.3% decline in third-quarter earnings vs. a 23.1% decline in April. For the fourth quarter, analysts are now expecting S&P 500 technology sector earnings to fall 38.7% compared with expectations in April of a 0.6% rise for the quarter.

2. Dollar Weakness Could Sap Stocks

The dollar has begun to weaken and that could cause foreign investors to pull out of U.S. equity markets. During trading Wednesday, the dollar traded at five-month lows against the euro and the Swiss franc, and a two-month low vs. the Japanese yen. "The weakness in the dollar is becoming more and more important," said Ricky Harrington, chief technical analyst at Wachovia Securities. "Foreigners own high stakes in stocks and other assets in the U.S. Before, their holdings were appreciating, but they're not now, so they could pull out." Foreign investors bought more than $66 billion in U.S. stocks during the first five months of this year, and have bought close to $170 billion in stocks over the past year.

3. Economic Weakness May be Spreading

The

Beige Book for June and July showed that weakness in manufacturing had spread to the services sector and other businesses. That's bad news because the service sector has been holding up. If the weakness has spilled over to other areas of the economy, that raises a red flag that we may be headed toward a recession.

The Good News

1. Consumers

Still

Hanging Tough

Despite rising rounds of layoffs and more stock market losses, U.S. consumers continued to buy in July. Economists are optimistic that $38 billion in rebate checks now arriving on consumers doorsteps will allow them to keep propping up the U.S. economy. July retail sales were unchanged. Analysts were calling for a 0.2% decline. But excluding autos, and excluding the effects of lower energy prices, the numbers are pretty impressive. Sales at food service and beverage stores gained 1%, while general merchandise and apparel stores saw sales tack on 0.9%. Sales at sporting goods, hobby, book and music stores grew by 1.2%.

Those retail sales numbers could indicate that consumers pre-spent some of their rebate checks in July. Joseph Abate, an economist at Lehman Brothers, thinks the rebate checks will contribute a full 1% to gross domestic product this year, putting his full-year GDP growth forecast of 1.8%.

2. Hints of Recovery Emerge Outside of Tech

For the first time in 10 months,

industrial production didn't decline in July. Instead, it came in flat. And excluding the 2.4% decline in production at information technology companies, production actually rose 0.2%.

Nontech companies are also operating more efficiently than they have in a long time. While the capacity utilization rate for tech companies dropped to an all-time low of 65.1%, nontech manufacturers' capacity utilization rate posted its first gain since August 2000 in July.

3. Fed to the Rescue

The Federal Reserve is expected to cut interest rates a seventh time this year next week. While the Fed's most aggressive rate-cutting program since the 1980s hasn't done a whole lot for the stock market yet, it tends to take time for rate cuts to work their magic. Historically, the stock market has jumped an average of 20% in the 12 months after a first rate cut.

With its rate-cutting program of the past eight months, the Fed has injected a huge amount of new cash into the economy. In June, the M3 broad money supply measure, which includes currency in circulation, money in savings accounts and deposits over $100,000, registered its highest year-over-year gain since 1982. Greater money supply tends to correlate with rising stock prices, as more available money in the financial system finds its way into financial assets, including stocks.