MAYBE IT WAS THE NEW YEAR’S CHAMPAGNE
For a year that started off with a heady feel,with the markets trying to break out past the 11,000 mark on the Dow, 1200 on the S&P 500, and 2200 on the Nasdaq, it got a hangover fast. The market displayed better-thanexpected fundamentals in the first quarter (i.e., earnings/economic growth), but got tripped up on those other great lubricators (after champagne)—money and oil. The worldwide geopolitical outlook got a little bit better, especially in the Middle East, but it was overtaken by inflationary concerns prompted by strong economic growth here at home.

The what and the where
Sure, there was a little bit of profit-taking, but solid fundamentals had been moving the market sharply upward ever since the national elections in November lifted the veil of uncertainty surrounding the direction of policy (any policy), from war to taxes to social security.

It wasn’t so much that Wall Street preferred Bush over Kerry. It’s just that you couldn’t find two more fundamentally different fellows, and the Street hates uncertainty. Buoyed by a sharp rise in consumer confidence to the highest levels since July, the market got a nice Santa Claus bounce in December.

The market conclusively reversed itself after a mostly sideways-to-down year. Indeed, we finished the fourth quarter modestly up for the year as measured by the S&P, with most of that gain coming in December.

Commencing with the first trading session of the new quarter, however, the market promptly reversed its reversal and began to move mostly sideways-to-down for the first quarter. The substantial gains made since November are now, substantially, a memory.

But hey, the economy is still strong, as shown by a strong mid-February rally. Uncertainty among the drug makers on several high-profile/high-profit drugs, as well as SEC investigations into Merck, produced a drag on the market. This was somewhat mitigated by the usual first-quarter lineups of mergers and acquisitions. The regulatory environment continued to be hostile to Wall Street, with several high-profile targets, notably insurers Marsh & McLennan, AIG, and General Re Corp., in the crosshairs of New York Attorney General Eliot Spitzer.

Stocks immediately fell off the 1200 level on the S&P 500 after a worse-than-expected jobs report at the beginning of the year. Rally attempts at 1167 in late January met fierce resistance on oil price hikes and inflationary concerns.

Better-than-expected job reports, combined with expectations of higher GDP growth and core Consumer Price Index (CPI) numbers, undid a late February rally that sent the S&P to highs of 1228 by mid-March.

Too much of a good thing?
It seems the economy was sneaking a few cookies over the holiday period. Like a lot of folks, its ever-increasing waistband kind of caught up with it this quarter, some months after its binge began. Perversely, the growth of non-farm payrolls, which showed a little weakness at the beginning of the quarter, and was a good excuse for profit-taking then, started showing unique strength towards the end of the quarter and has added to inflationary worries— further weakening the market.

"Caution," say the experts, "this consumer price inflation is different than any we have seen in 10 years."

The usual story—"We want growth. Just not a lot of it"—predominates. So now, it’s inflation, inflation, inflation coming from the Fed, analysts, and investors. Thankfully, our good friend Mr. Waistban…err, Greenspan has put the economy on a diet with the seventh 0.25 basis-point rate hike since late June of last year. Short-term rates now stand at 2.75% and, ironically, the major indices are within a whisper of their averages from June of ’04 when the Fed first began to hike rates. Hopefully the Fed can do as good a job of holding down consumer prices without killing the economy as they have done of holding down equity prices.

Oil prices at or near $58 per barrel haven’t helped much to fuel a pop in equities with the worries that inflation may be out of control.

Still, higher oil prices may have a somewhat anti-inflationary effect, as people may have less money in their pockets each time they spend $50 to fill the tank.

Earnings continued to be robust for the fourth quarter. According to Zacks Investment Research, 66% of companies in theS&P 500 reported fourth-quarter earnings that exceeded expectations; 16% met expectations; while 18% were below expectations.

Overall earnings grew by 28%, while revenues were up sharply—13% for companies in the S&P 500. Earnings growth was in line with expectations, while sales growth was modestly above the estimate of 12%. In the first quarter, earnings are expected to be halved, while revenue growth could shrink by 30–40%.

The energy and material sectors both saw earnings growth in excess of 100%, while the technology sector posted a 54% gain in earnings per share and the industrials saw solid earnings growth of 24%.

So what’s going on here?
There is an interesting dynamic going on with mid- and small-cap companies. They are retaining a substantial amount of the price value that they have built up over the last nine months, despite the short-term correction in the major indices like the Dow, Nasdaq, and S&P.

Indeed, if you look at the Semiconductor Index, S&P Mid-Cap, and even the S&P Small-Cap indices, you can see technical support holding up very nicely in each.

Keep a sharp eye on the volatility of these indices as a guide to what might happen in the major indices—any deterioration could signal trouble for the broad market.

On the downside, don’t look for the financials, including banks and insurance companies, to rebound anytime soon. A worsening interest-rate environment combined with a hostile regulatory environment is likely to keep pressure on these sectors.

A bit on the technicals
Volatility should continue as the market tries to change direction. With the VXN churning sideways around 17–19 since early February, the Nasdaq may still have some downside before reaching a bottom. The VIX has seen a sharp rise moving from a low of 11.10 set on February 16 to its close of 14.09 for the first quarter.

Upward movement generally indicates that the S&P is beginning to become a little oversold. However, on a relative basis, the VIX has a ways to go before a strong rally is likely to occur. A close above 20 is considered necessary for a rally to be sustainable. (VXD data is too new for analysis.) However, the Dow Jones Industrials finished below its 20- and 50-day moving averages at 10,610 while closing above its 200-day moving average of 10,400. Expect support at 10,400 and resistance at 10,850.

The S&P also finished below its 20- and 50-day moving averages of 1195, while remaining well above its 200-day moving average of 1150. Look for the S&P to encounter resistance at 1220 and get support at 1162.

On the Nasdaq, the index closed just a whisker above its 200-day moving average of 1998 while finishing well under the 20-day MA of 2020 and its 50-day MA of 2040. Expect support at 1950 with resistance at 2085.

Eyeing the future
The second quarter will likely be dominated by three themes: oil prices, earnings, and inflation. The sharp spike in oil prices is likely to help slow inflationary pressure in the energy component of the CPI. So a more aggressive policy by the Fed regarding interest rates would have to be viewed as unfavorable for the market. If oil prices continue to close above $50 per barrel, the Fed should continue its "measured" approach to interest rate hikes (i.e., 0.25 bps rather than 0.5 bps).

As interest rate hikes begin to affect corporate earnings, investors should keep a weather eye out for earnings shortfalls. With money a bit tighter than in the past few years, earnings will be harder topredict, as will revenue growth. Until there’s some consensus on just about how far the Fed will raise rates, and until we absorb the unsettling realization that high oil prices could stick around for a while, we may continue to see the yo-yo markets that have stuck with us for the past year.