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I believe the U.S. economy will slip into a recession over the next two years and that U.S. stocks have entered a bear market . My main reason for these predictions is stress in the banking system caused by the weak housing and real estate markets.

While fundamentals are clearly deteriorating, the technicals on the major equity averages are showing some negative divergences. However, they're not yet weak enough to confirm the bear market based on pure technical analysis.

Complacency vs. Wishful Thinking

The major equity averages turned in mixed performances for the first quarter, but only the Dow industrials and the semiconductors ended the quarter lower. During the quarter, several indices, such as the Dow Jones Industrial Average, the S&P 500, the Nasdaq, the Dow Jones Transportation Average and the Dow Jones Utilities Average, set new all-time highs. However, the increased volatility, which we've seen since I made my bear market call on Feb. 20, is typical of a market setting a multiyear high amid numerous bear tracks.

In February, the bulls became complacent but stayed the course even after the Dow plunged 416 points on Feb. 27. The volatility since then is normal, say the bulls, but in my judgment that's just wishful thinking.

Let's take a look at the averages.

First-Quarter Scorecard
Market Current Price % Gain or Loss 2006 Close 2007 First Half High Percent Off High 2007 First Half Low
DJIA 12,354 -0.9% 12,463 12,796 -3.5% 11,940
S&P 500 1,421 0.2% 1,418 1,462 -2.8% 1,364
Nasdaq 2,422 0.3% 2,415 2,531 -4.3% 2,332
Utilities 500.18 9.5% 456.77 505.15 -1.0% 443.78
Transports 4,811 5.5% 4,560 5,211 -7.7% 4,565
Russell 2000 806.00 1.4% 794.90 831.5 -3.1% 756.10
The SOX 465.57 -0.3% 467.04 492.27 -5.4% 448.57
Source: RightSide.com

First, the Dow Jones Industrial Average slipped 0.9% in the first quarter of this year and fell 3.5% from its all-time high of 12,796 set on Feb. 20. The Dow is between my new quarterly pivot at 12,312 and my semiannual pivot at 12,492. With declining weekly momentum, a weekly close below 12,312 is more likely than a weekly close above 12,492.

On the daily chart, you can see that the Dow is below its 50-day simple moving average at 12,454, which indicates risk to the 200-day simple moving average at 11,900.


Dow Jones Industrial Average
Click here for larger image.
Source: Reuters

Among the other major averages, the S&P 500 is below a new quarterly resistance at 1448.20, below the multiyear high. On the Nasdaq, quarterly support is 2274, with my annual pivot at 2483 and quarterly and semiannual resistance at 2544. For the Dow Jones Utilities Average, my monthly pivot is 492.35, with semiannual and quarterly resistances at 507.00 and 511.13, respectively.

I believe a key warning comes from the Dow Jones Transportation Average. It set a new all-time high of 5211 on Feb. 22, and the quarter's close was 7.7% below that high. Transports are noted as a leading indicator for the economy, so I consider this index one of my bear tracks. Semiannual support is 4360 with a quarterly pivot at 4749 and monthly, quarterly and semiannual resistances at 4985, 5074 and 5280, respectively.

The stock market is operating under a Dow Theory Buy -- Nonconfirmation, which happens when the Dow industrials don't follow the transports to a new closing high. With the Dow Jones Industrial Average now some 400 points below its closing high of 12,795.93, a new confirmation appears difficult. This is another one of my bear tracks.

Among other commonly followed measures, Russell 2000 futures ended the quarter 3.1% below the new all-time high of 831.50, set on Feb. 22. My annual and semiannual supports are 763.20 and 750.77, respectively, with a monthly pivot at 808.26, quarterly resistance at 852.86 and monthly resistance at 853.92.

The Philadelphia Stock Exchange Semiconductor index, or SOX, is down 5.4% from its Feb. 26 high of 492.27. Keep in mind that the SOX peaked at 560.68 in January 2004 and at 559.60 in January 2006, and it has declined nearly 17% from those peaks. This is another bear track, as technology is another leading indicator for the U.S. economy, with semiconductors a raw material for growth.


Philadelphia Stock Exchange Semiconductor Index
Click here for larger image.
Source: Reuters

I don't show any supports from my model, so a weekly close below the 200-week simple moving average at 454.42 would be yet another bear track. The SOX is below semiannual and quarterly pivots at 475.26 and 482.15, with quarterly and monthly resistances at 509.26 and 514.09, respectively.

Stretched Equity Valuations

Many strategists have lowered earnings growth estimates from the high single digits to low single digits. Plus, several sectors, such as basic industries, capital goods, consumer services, energy and transportation, ended the first quarter more overvalued than they were at the end of 2006. Consumer durables, consumer nondurables, finance and public utilities are slightly less overvalued. Health care and technology are less undervalued.

Basic industries are more overvalued on renewed speculation in precious metals and on M&A potential involving industrial metals. Energy is also more overvalued as geopolitical risks mount, such as the latest standoff between the U.K. and Iran; this sector has 29 of 93 strong buy ratings.

The finance sector is less overvalued as it weakens on the fallout from real estate woes. The subprime mortgage mess is the tip of the iceberg, with balance-sheet issues growing at community and regional banks. According to recent FDIC data, banks are exposed to $565 billion in construction and development loans, which represent about 60% of the pipeline of commitments to the industry.

Investors are flocking to the dividend and M&A prospects in public utilities. If the sector returns to fair value, it could take at least five years for dividends to offset share-price weakness.

Valuations, Sector by Sector
Sectors 29-Dec-06 30-Mar-07
Basic Industries 11.8% overvalued 17.5% overvalued
Capital Goods 4.0% overvalued 6.4% overvalued
Consumer Durables 16.9% overvalued 15.9% overvalued
Consumer Non-Durables 13.6% overvalued 11.6% overvalued
Consumer Services 5.7% overvalued 7.1% overvalued
Energy 0.2% overvalued 9.3% overvalued
Finance 10.1% overvalued 4.8% overvalued
Health Care 3.1% undervalued 1.4% undervalued
Public Utilities 17.5% overvalued 16.2% overvalued
Technology 3.2% undervalued 0.4% undervalued
Transportation 8.3% overvalued 10.4% overvalued
Source: ValuEngine
At time of publication, Suttmeier had no positions in any of the stocks mentioned in this column.

Richard Suttmeier is the chief market strategist for RightSide.com, where he writes the Small Stocks and Sector Report. Early in his career, he became the first long bond trader for Bache and later began the government bond department at LF Rothschild. Suttmeier went on to form Global Market Consultants as an independent third-party research provider, producing reports covering the U.S. capital markets. He has also been the 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. He appreciates your feedback; click here to email him.