All of the major equity averages seemed to be poised for renewed vitality as October began, but raised inflation expectations caused an abrupt shift Tuesday and Wednesday.

The two-day rout has left the major equity averages on the edge of negative weekly chart profiles. They must close above their five-week modified moving averages Friday to prevent that.

Even the Dow Jones Utility Average, after hitting an all-time high of 438.72 on Tuesday, is on the cusp of its five-week MMA at 414.24. A close below last week's low of 419.21 would be a weekly key reversal.

Seeing higher energy costs with Nymex crude oil declining does not bode well for the economy or for stocks. Consumers are being forced to cut energy usage because of higher prices on supply shortages caused by hurricanes Katrina and Rita. This is a tax on the economy, and concerns have been reflected in recent weak readings in consumer confidence.

The lack of confidence is causing a reversal in stock prices even on days when crude oil prices decline. It appears that the storms will be a bigger drag on the economy than anticipated by the Federal Reserve and Wall Street economists. This environment is not healthy for stocks.

Bond yields are starting to rise as the bond conundrum winds up. Higher bond yields lower the calculation of the fair value for every stock in the market, and that in turn makes undervalued sectors less undervalued and overvalued sectors more overvalued. This makes a fourth-quarter rally more difficult to sustain.

Perhaps investors who are strapped to pay their energy bills, or who may have lost their home or business along the Gulf Coast, are cashing in some equities to make ends meet.

Third-Quarter Results
Date The Dow S&P 500 Nasdaq Utilities Transports Russell SOX
June 30 10275 1195.9 2057 386.59 3488 642 419.07
Sept. 30 10569 1234.2 2152 432.38 3741 670.25 475.32
Change 2.86% 3.20% 4.62% 11.84% 7.25% 4.40% 13.42%
Value Area 9234 S 950.8 S 1552 S 373.40 A 3187 S 581.65 A
Supports 10192 M 1191.7 M 1969 M 389.89 Q 467.66 W
Pivots 10527 W 1228.8 W 2113 W 434.86 W 3634 W 660.98 M 481.98 M
10502 M 1233.8 M 2102 M 430.69 Q 3717 M 664.93 W
Five-week MMA 10541 1228.8 2143 414.14 3671 664.64 467.58
Five-month MMA 10474 1203.5 2091 382.33 3623 642.64 446.45
Resistances 2319 Q 435.19 M 487.90 Q
Risky Area 11620 Q 1349.2 Q 3872 A 747.73 Q 535.64 Q
13498 A 1611.1 A 3141 A 3940 A 666.70 A
Source: Global Market Consultants

As the above table shows, the equity averages posted positive results in the third quarter. The prospects of sustaining these gains has become less likely because of evidence of inflationary pressures in Monday's ISM report and Wednesday's nonmanufacturing ISM data.

If the equity averages don't return to and close above the five-week modified moving averages by next week, stocks will be vulnerable for the remainder of the year.

In other words, the markets must survive the release of the employment report Friday morning and the consumer price index on Oct. 14. In the Tech Trading Diary Tuesday, I summarized the risk/reward for the Nasdaq simply -- Nasdaq 2300 or bust.

If Friday's closes are cheaper than the five-week modified moving averages, the weekly chart profiles will shift to negative, and the downside will be to the monthly supports shown above.

After a high of 10,608 on Monday, the Dow Jones Industrial Average declined below my monthly support at 10,502, which will become a monthly pivot for the remainder of October. The key level to hold is monthly support at 10,192, but a weekly close below the five-week modified moving average at 10,541 would shift the weekly chart profile to negative.

S&P futures hit a high of 1238.8 on Monday but subsequently failed to hold monthly and weekly pivots at 1233.8 and 1228.8, respectively, with monthly support looming at 1191.7. A weekly close below the five-week MMA at 1228.8 would shift the weekly chart profile to negative.

After the Nasdaq Composite Index closed at a high of 2167 on Tuesday, it failed on Wednesday to hold my weekly support level at 2113. It closed a point above monthly support at 2102. Lower monthly support is 1969. A weekly close below the five-week MMA at 2143 would shift the weekly chart profile to negative.

After another new all-time high at 438.72 on Tuesday, the utilities index reversed hard on Wednesday but ended the day above the five-week MMA at 414.14. Utilities failed to hold weekly, monthly and quarterly pivots at 434.86, 435.19 and 430.69 respectively, which are now considered resistances.

A close this week below last week's low of 419.21 would be a weekly key reversal, but a weekly close below the five-week MMA at 414.14 may not shift the weekly chart profile to negative as the 12x3 weekly slow stochastic will likely still be above 80 on a scale of zero to 100.

Transports reached a high of 3758 on Tuesday, but failed to hold my monthly pivot at 3717, and ended Wednesday just below weekly support at 3634. A close on Friday below the five-week MMA of 3671 would shift the weekly chart profile to negative.

After Russell 2000 futures hit a high of 678.00 on Tuesday, weekly and monthly supports at 664.93 and 660.98, respectively, failed to hold Wednesday. A weekly close below the five-week MMA at 664.64 would shift the weekly chart profile to negative.

Monday's high of 483.20 on the Philadelphia Semiconductor Index (SOX) was between my monthly pivot at 481.98 and quarterly resistance at 487.90. A weekly close below the five-week MMA at 467.58 would shift the weekly chart profile to negative.

Dual Indicators

At the beginning of the year, every sector was overvalued according to my models, except for technology, which was 11.67% undervalued. The Dow and the Nasdaq also swung into 2005 with overbought 12x3 weekly slow stochastic readings. Given these overextended profiles, it was not surprising to see the selloff from first-quarter highs to second-quarter lows, as these dual indicators were too strong to be sustained.

The Nasdaq peaked first with a high of 2191 on Jan. 3. The Nasdaq low for the year was 1890 on April 29, which was a pullback of 13.7%. The Dow did not peak until March 7 with a high of 10,984. Of equal significance, in my judgment, is that the Dow's 2005 low on April 20 was above 10,000 -- if only by a single point -- a pullback of 8.9%.

Helping both the Dow and Nasdaq move higher was the bond conundrum. The yield on the 30-year bond, an important input in my valuation model, declined from 4.825% at the beginning of the year to 4.151% on June 3, down 67.4 basis points in the face of the FOMC's rate-raising policy.

With stocks cheap compared with bonds, the Dow and Nasdaq stabilized. Leadership was provided by the tech-heavy Nasdaq, which reached a four-year high of 2219 on Aug. 3, up 17.4% from the April 29 low of 1890. The Dow lagged; its third-quarter high of 10,719 was set on Aug. 10, up 7.2% from the April 20 low of 10,001.

I looked for leadership from the Philadelphia Semiconductor Index, which rallied 29.1% from 376.64 on April 29 to 486.34 on Aug. 2. In my judgment, stocks reversed in August when crude oil moved above $62 a barrel. But with economic damage done and with higher interest rates projected, a break back below $62 may not provide relief.

A significant bullish moving average crossover on the weekly chart profile for the SOX was confirmed on July 8: The five-week modified moving average moved above the 200-week simple moving average for the first time since November 1998. The five-week MMA had been below the 200-week SMA since September 2001. The five-week MMA ended September at 467.27, well above the 200-week SMA at 423.93. This signal helped the SOX to a 9.7% year-to-date gain.

The semiconductor industry ended the quarter at 19.39% undervalued, and the broader tech sector was 9.85% undervalued, an improvement from the start of the year, when it was 11.67% undervalued.

Year-To-Date Results
Date The Dow S&P 500 Nasdaq Utilities Transports Russell SOX
Dec.-04 10783 1211.3 2175 334.95 3798 652 433.31
Sept. 30, 2005 10569 1234.2 2152 432.38 3741 670.25 475.32
YTD Change -1.98% 1.89% -1.06% 29.09% -1.50% 2.80% 9.70%
Source: Global Market Consultants

Through the first three quarters of 2005, the Dow utilities are up 29.1%, quite a momentum move as public utilities began the year 9.02% overvalued and ended the third quarter at 11.45% overvalued. Health care has been trading around its fair value all year. All other sectors are less overvalued at the end of the third quarter, mainly because the 30-year yield is lower.

If my call for higher 30-year yields is correct, a higher 30-year yield in the fourth quarter should make the overvalued sectors more overvalued and technology less undervalued. However, technology clearly remains the cheapest sector as we begin the new quarter.

Sector Valuations
Sectors Valuation On Dec. 31, 2004 Valuation On Sept. 30, 2005
Basic Industries 24.50% overvalued 9.43% overvalued
Capital Goods 17.65% overvalued 6.15% overvalued
Consumer Durables 12.41% overvalued 2.11% undervalued
Consumer Nondurables 17.34% overvalued 1.40% overvalued
Consumer Services 11.88% overvalued 1.71% undervalued
Energy 22.15% overvalued 17.2% overvalued
Finance 14.44% overvalued 3.71% overvalued
Health Care 1.32% overvalued 1.34% undervalued
Public Utilities 9.02% overvalued 11.45% overvalued
Technology 11.67% undervalued 9.85% undervalued
Transportation 28.44% overvalued 2.66% overvalued
Source: ValuEngine.com

Richard Suttmeier is president of Global Market Consultants, Ltd., chief market strategist for Joseph Stevens & Co., a full service brokerage firm located in Lower Manhattan, and the author of TheStreet.com Technology Report newsletter. At the time of publication, he had no positions in any of the securities mentioned in this column, but holdings can change at any time. Early in his career, Suttmeier became the first U.S. Treasury Bond Trader at Bache. He later began the government bond division at L. F. Rothschild. Suttmeier went on to form Global Market Consultants as an independent third-party research provider, producing reports covering the technicals of the U.S. capital markets. He also has been U.S. Treasury Strategist for Smith Barney and chief financial strategist for William R. Hough. Suttmeier holds a bachelor's degree from the Georgia Institute of Technology and a master's degree from Polytechnic University. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he invites you to send your feedback -- click here to send him an email.

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