Stocks are at a real crossroads this week, as a trifecta of events conspire to make this potentially the most pivotal period of the year. The outcome could determine the market's direction for the next several months.

If stocks end this week lower, conservative growth investors may wish to sit out the next couple of months in cash, as an increase in downward volatility could sap their willingness to wait out the severe downdrafts that may lie ahead. More aggressive private investors may want to create portfolios that could provide buoyancy, and perhaps even an absolute lift, in difficult seas.

The problem is that this year is shaping up to resemble 1997-99 or 2000-02 much more than 2003. In those earlier periods, there were distinct groups of stocks that went up most of the time and distinct groups of stocks that went down most of the time. In contrast, in 2003 there was a broader rise in the market that lulled many investors into complacency.

Don't Look Back

To stay on the positive side of the ledger this year, investors need to focus their attention on the sectors and market-capitalization segments that are in favor, and not pine for the past or hope for the best. That means small- and midsized names in energy, steel, real estate investment trusts, and defense and utilities. It means turning a blind eye to the formerly go-go technology, retail and biotech sectors -- except for occasional trades.

What's happening? After slopping around the flat line for months, the Dow Jones Industrial Average took a turn for the worse last week and slipped to a -3% return for the year, while the Nasdaq Composite sank to the -6% level.

Even small-cap and mid-cap stocks, the last refuge of the past three years, ended the week slightly down for the year. When you consider that the Nasdaq was up as much as 7% this year, that's a tremendous descent. The last person to buy the Nasdaq 100 Trust ( QQQ) in January is in a world of hurt, and he has a lot of company.

The recent declines have pushed big-cap stocks below levels that have provided support in the past: their 200-day moving averages, or the average price paid over the past 50 weeks. While investors who strictly focus on business fundamentals consider these levels little more than squiggly lines on a price chart, many sophisticated trading systems at hedge funds and brokerages are geared to sell stocks aggressively when the indices sink beneath these levels.

The Trouble With the Bullish View

The optimistic point of view on the recent erosion is that stocks have simply gone back to their lows of the year for the third time after already being near their year highs three times. According to world-weary bulls, that is the very definition of a good old-fashioned trading range, and it's nothing to worry about. The fact that the top of the range, approximately 1150 for the S&P 500, has gotten progressively lower (although only slightly) is not pretty, the bulls admit.

But they say it's more important that the size of the corrective phases has fallen well within historic norms. Their mantra: Quit your whining. Buy stocks at the bottom of the range (i.e., right now) and sell them at the top of the range (i.e., perhaps in a few weeks), and all will be fine.

What's wrong with this broadly bullish view is that the market always operates on the two axes of time and price. Sometimes time is important; sometimes price is. Large-cap bulls are focused on price now, but after a long period of slop, time is often more critical. That's because the longer it takes for an expected positive event to occur (e.g., a sharp rebound from the bottom of a range), the more impatient potential buyers become. The 200-day moving averages, which had been rising, plateau and begin to decline. At some point, shareholders decide to stop waiting for reinforcements to arrive and simply liquidate their positions on the next volley of bad news. If this happens en masse, the bottom can drop out of a quiescent range-trading market, resulting in a sharp, fast collapse.

Love That Perverse Diversity

Will such a collapse occur? It could happen for many popular stocks, while others cruise along just fine. The market is perversely diverse. The late 1990s are best remembered for the dramatic rise in large technology stocks, but large value stocks, as well as nontech small-cap stocks, were systematically ruined.

Similarly, in the 2000-02 period, tech and energy stocks were trashed, but small- and medium-sized regional banks, homebuilders and real estate investment trusts all advanced to new highs as if they hadn't a care in the world.

Paul Desmond, head of institutional research firm Lowry's Reports, says that this sort of complexity probably has always existed in the market, but statistical measures were not set up to capture it. Today, the market is sliced and diced a million different ways via a variety of indices that let us understand micro-climates within the big market ecosystem. He thinks big-cap Nasdaq stocks may be headed back to their 2002 lows while relatively cheap makers of steel and oil, and gas drillers, coal miners and munitions makers gun to new highs.

Indeed, he notes that if investors would stop fixating on the Nasdaq or the market-cap-weighted S&P 500 and look at a broader range of stocks, they'd feel a lot more comfortable. He says his firm's unweighted index of New York Stock Exchange domestic "operating" companies -- that is, the NYSE Composite minus closed-end funds, preferred shares and foreign companies -- hit a new high in late June and is only slightly off that level now. "On the Big Board you have the majority of stocks still going up," he said.

Weapons of Mass Delusion

As for those pesky tech stocks, well, it could get ugly. Michael Belkin, the dour independent analyst who is virtually alone in having predicted the absolute rout of the semiconductor group this year, has the hot hand in this arena.

In an interview last Friday, he said he was sticking to his May 2004 and October 2003 comments that defensive consumer-products companies will outperform their peers in 2004 and that tech stocks are headed straight back to their 2002 lows.

He chided mainstream Wall Street analysts for having suffered an intelligence failure on par with CIA and FBI analysts for hyping such "weapons of mass delusion" as the notion that the 2003 rally meant the world was experiencing a lasting industrial economic recovery. As investor sentiment shifts toward an understanding that 2003 was merely a cyclical bull rally within a big bear market, he believes that "sustained liquidation of mutual funds" a la 2001-02 should ensue. He points out that the Nasdaq, S&P 500 and European indices are all stuck at their declining 200-week averages, which is the distinguishing characteristic of a long-term downtrend.

The Two Big Factors

My own view is that the improvement of energy and steel stocks has not anticipated a worldwide economic rally, as most economists seem to believe, but rather two separate phenomena:

  • It's possible that energy is up in anticipation of weakening supply (lower production of oil from the Middle East) and rising demand (the prospect of a colder-than-usual winter in Europe and the U.S.).
  • It's possible that steel, copper and coal are rising because central banking authorities in China have not succeeded in dampening growth in the provinces, and world basic-material exports are rising again to fill its massive industrial maw.

By the same token, it's possible that most other stocks are sinking in anticipation of a slowdown in economic growth and consumer demand in the U.S. and Europe, as well as the prospect of higher taxes in a Kerry-Edwards administration. If the broad indices close near their low at the end of this week, just prior to the Democratic Convention, watch out below.

Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. At the time of publication, Markman had no positions in any of the stocks mentioned in this column. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at sm@jonmark.com; please write COMMENT in the subject line.

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