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Dow Rally Above 11,000: Now What?

July 12, 1999

The exact wording of a key portion of the Fed's official statement following its June 30 Federal Open Market Committee meeting read: "...the FOMC has chosen to adopt a directive that includes no predilection about near term policy action." That was all the U.S. stock market needed to rocket up 200 Dow points off its low to touch 11,000 again for the first time since May 13.

The Fed's wording indicates that their policymaking arm, the Federal Open Market Committee, has moved from a tightening bias to a neutral bias. The Fed's bias indicates their predilection about near term policy action, and the move to a neutral bias June 30 suggested to the market that it has the best of both worlds: a successful, inflation-fighting Fed that will raise rates when necessary to keep inflation at bay, and a neutral bias indicating that there is less chance than the market originally thought that the Fed would tighten again at its next FOMC meeting in August.

Yet, by Thursday morning the bond market was selling off again after Wednesday's post-FOMC rally. Bonds, which have been in a downtrend due to the robust U.S. economy, perhaps took another look at the Greenspan Fed's history during periods in which it has raised interest rates. The last time the Fed raised rates repeatedly was during 1994, when the bond market was also falling at its steepest rate in years (since 1927, to be exact). In each of the six times the Fed raised rates, it moved to a neutral bias upon announcing each rate hike.

The Fed, then, is acting with precedent, and is still on inflation watch. It may hike rates yet again this year, as the next sentence of their June 30 statement implies: "The committee nonetheless recognizes that in the current dynamic environment, it must be especially alert to the emergence, or potential emergence, of inflationary forces that could undermine growth." In the least, the Fed has recently communicated to the markets that it will use changes in bias to make known its intentions. Perhaps the Fed desires to have the ability to return to a tightening bias between meetings if upcoming economic numbers are too strong for its taste.

So, here we are again at Dow 11,000, Wednesday's sharp rally also helped by end-of-quarter "window dressing" as portfolio managers sought to put stocks back into portfolios. Other money managers perhaps had to rethink strategy after the Fed's surprise move to a neutral bias, and after the rate hike turned out to be only 1/4 point at the Fed Funds level and the Discount Rate remained unchanged at 4 1/2%. Wednesday's rally had all the symptoms of money managers moving back into stocks after discovering that the Fed was less aggressive than most anticipated.

Indeed, as our commentary has indicated, the corrective process in the stock market into the series of short-term cyclic lows due largely in June (one in early July) had been gentle even though the market staged a 1987-style 49% advance in the few months since the dominant 4-year cycle bottomed the global markets last fall. This is despite the fact that statistics show that mutual fund inflows have declined 36% since April, and are down 30% this year over last. The liquidity generated by the record surge in investor participation in the market the past couple of years, combined with global liquidity still floating around the world in an easy-money environment, has helped keep the market propped up after reaching a turning point in April and in May.

Both the April turning point and the market's tendency to peak thus far near long-term resistance at Dow 10,922 and S&P 1371 (+/- 1 1/2% margin for error) were forecast as part of the most probable path for 1999 in our annual forecast report, which this year is entitled Forecast '99: Investing During The Void. Now, after beginning the second half of 1999--the last two quarters of an entire millenium--the market begins a more difficult period. During this second half of 1999, it has its work cut out for it as different factors descend on the global economic and political environment during that second half. These factors--and the most likely outcome for this year--are presented in detail in that report, and are updated in regular issues of our monthly market letter, The Global Market Strategist®, which also includes recommendations on how and when to rebalance investment portfolios as conditions within the investment markets change.

The most important point here: now is the time to rebalance portfolios, no matter what one's outlook is for the future. Rebalancing becomes necessary when the risk/reward equation changes, not merely when one's opinion flip-flops around. That risk/reward equation changes even during good times, after the stock market has advanced and alters the ratio of investments in one's portfolios. And, it changes when the level of risk changes. The need to rebalance will become even more important if the Dow manages to break out above 11,000 and soars to still higher levels, which is probable now that the corrective process into the June cyclic lows is complete.

I conclude today by observing one possibly fly in the ointment for the stock market. The Dow Utility Averages, which very typically lead the Industrials and the general market up as well as down, plunged after the Fed's announcement June 13. The Dow Utility Average peaked June 16 and has been falling ever since. If it does not recover, and if it continues its decline, it may be telling a tale of the next direction for the U.S. stock market--perhaps the same tale the bond market has been telling all year as it has staged its steepest decline since 1994, which in turn was its steepest decline since 1927.

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