Down 777, Up 485: Another Special Market Comment

Nice rally today. It didn’t get much commentary in the financial press but all day I was telling contacts that the infrastructure of Wall Street benefited from a big up day because it was quarter end. While I am not a conspiracy theorist I suspect that played a role in the rally.

Another thing I believe played a role that received little comments was sharp drop in the Dow and S&P averages after the close on Monday. I posted about this on RealMoney.com stating "My one minute chart on the S&P shows a 4 PM price of 1124. I then show steady deterioration to the posted close of 1106.42 which occurred at 4:23 PM. The Dow chart show something similar with a decline of around 150 points after the 4PM close."

S&P Futures never traded near the cash close, holding at 1115 to 1120 vs. the printed NY close of 1106. When the futures reopened at 4:30 and did not sink it was clear that all else equal overnight a rally was in store to recoup 1-2% on the open.

I've been telling clients since September 17th and18th when Morgan Stanley and Goldman melted down that I thought we were in the process of bottoming. Yesterday's rally helps the cause but we need to stop with the huge daily moves. I don't think down 800, up 500 builds much confidence in the market.

I am in favor of the bailout plan as I see it as emergency surgery to save the patient before a new program of long-term treatment can be implemented. I would have preferred to see the House pass it on Monday. However, the timing of the vote, just prior to a holiday, might have proved helpful. We got a day where things calmed down a bit. There was less emotion and we had a chance for some other parts of the rescue program to develop, most importantly, the possible changes in mark-to-market accounting. We had less panicked talk (some have accused me of inciting it) and the markets got to function a bit (the relatively good performance in Asia and especially Europe overnight Monday helped greatly).

I remain of the view that the resiliency seen in the economy since the credit crisis really started in the summer of 2007 will re-emerge as it recedes. I am not saying the economy won’t slow further or decline just that it won’t slow or decline as much as conventional wisdom believes.

I think stocks are bottoming because Wall Street can deal with economic issues now that it is accepting the magnitude of credit crisis and taking big enough steps to wall it off. Wall Street has not been able to deal with and efficiently price the credit crisis. I believe Wall Street can deal with the efficiently price a weak economy. To me, that is a game changer and balances the risk-reward tradeoff for stocks.

Mortgage Refinancings a Bullish Development

I spent yesterday afternoon and evening traveling from Chicago to Salt Lake City on my way to the Sundance Film Festival in Park City.

In the morning, I chatted with my mortgage broker. He told me he was getting flooded with calls but not a lot of action yet. He said he many clients that are in position to refinance with 30 year fixed rate mortgages now at 5.4% and falling. One undeniable fact about the 175 basis points the Fed has cut is that it has brought mortgage rates way down. Tony has chronicled this well including the impact it can have on the subprime resets. If mortgage rates drop much further (Bill Gross thinks the Fed is targeting 4% to 4.5% for mortgage rates), it will be a huge boost to the beleaguered and unconfident consumer. Oil has backed off and heating season is going to be over soon. And more rates cuts are on the way.

With this in mind, I was pleased to read a Ned Davis Research report where their economist, Joe Kalish, noted that refi applications rose 17% last week to their highest level since March 2004. Furthermore, refi apps are up 150% in three weeks, the biggest increase in seven years.

Somewhere else I read that the average mortgage in the US carries a rate of 6.1% and nearly 70% of current mortgages could now be considered refinancable. That may have been on RealMoney but I was so busy preparing to leave for Utah that I didn't copy down a quote or link.

The bottom line is that interest rate reductions are starting to bite....

....The Fed has made it clear that growth is going to take precedent for the foreseeable future and more rate cuts are likely coming. The recent market decline is not going to have a v-shaped bottom that formed in the last two days but barring some major new bad news, the interest cycle alone should contain the downside and eventually will launch a major bull market. I'm not sure from what level or when and I'm willing to wait to get longer. As Rev Shark, my favrorite trader who writes for Real Money likes to say, there will be plenty of time and upside to make money after the market turns to a new uptrends.

Special Market Comment

Overseas markets continued to fall sharply last night in Asia and today in Europe. Two day losses in many markets while the US was closed for the Martin Luther King holiday reached 10% or more. US futures have been trading down between 4% and 7% since Sunday night.

In response to what can only be described as a global panic, the Federal Reserve cut the Federal Funds rate by 75 basis points to 3.50% at about 7:20 CST this morning. US markets initially cut their losses by about half but now, a half hour later, the market is right back to pre-Fed levels. Initial commentary on CNBC and websites like RealMoney.com are quite skeptical of the Fed action. They are stating that it reeks of desperation and is too little too late.

To be perfectly honest I have no idea what is going to happen in the short-term. We could head much lower as buyers just don’t seem willing to step up. We could also rebound quickly and sharply as short-covering ignites a rally that gives potential buyers some relief and confidence. I am surprised by the size and speed of this decline. I thought the market would be tough to navigate in early 2008 with risk skewed to the downside. However, I wasn’t expecting this.

I do not plan to trade today except to possibly do a little buying in accounts that are very heavy in cash reserves. The reason I would invest some money in these accounts today is that the Fed action reminds us that their will be a monetary and fiscal policy response that eventually will calm investor nerves and give the economy some traction for renewed growth.

Lower rates are a positive for the long run. Stock prices should be higher than current levels within six to twelve months as investors eventually look ahead to the next economic expansion. We may go lower first but at some point we will rebound. We also do. We always have.

The Fed cut might not help right away but it signals to me that this is not going to turn into a disaster. That means its time to hunker down, ride it out, and wait for stability at which time better decisions can be made without the emotion that lousy markets inevitably invite.

Market declines are very painful. It hurts to see your portfolios sink in value. But if you do not need your investments for a year or more this is painful experience but not the end of the world.

I am in the office and available if you want to talk further about the markets and your investments. I can be reached any time between 7:30 AM and 10 PM Chicago time.

Impact of Presidential Election

There is a lot more on investor's minds these days than the 2008 Presidential election. However, the Iowa caucuses are just 16 days away and recent polls indicate the races in both parties are extremely unpredictable. Who knows if past market patterns in Presidential election years will hold given the overwhelming focus on the health of the economy and the credit markets. But as a reminder, I want to pass along some info from a Ned Davis Research commentary that went out on Monday.

First, the market tends to trend down in the first half of a Presidential election year regardless of which party ultimately wins the election. The depth of the decline has been more severe in years where the incumbent party loses the White House. Second, the market has rallied from a June low through September regardless of the election outcome. This would seem to coordinate with the determination of the nominees and the optimism that is generally sought at the late summer political conventions. Third, the end of the year has been sensitive to whether the incumbent party wins. When the incumbent party has won, the market has continued to rally right through to year end. When the incumbent party has lost, the market has peaked in September and trended lower until mid-December. Finally, Like many years, Presidential election years have shown a tendency to rally in late December and this has occurred whether the incumbent party wins or loses.....

....You have not had to pay much attention to the political landscape to know that the Democrats are a big favorite to take the White House in 2008. Furthermore, Democrats are expected to add to their majorities in the House and Senate, especially the Senate where the map, open seats, retirements, and number of seats t defend all favor the Democrats. Put it all together and the market is likely to add the election cycle to its expanding list of worries.

Please beware that there are a very limited number of elections upon which this type of analysis is based and there is lots more going on every Presidential election year than the election so isolating movements on the basis of politics or election outcomes may not be possible. A great example of the uselessness of this data is that the market will sell off in fear of the Democrats even though market returns are far superior in periods when the Democrats have held the White House. Nevertheless, with the Iowa caucuses and the New Hampshire primary fast approaching and a very compressed primary schedule (look for nominees to be effectively determined on February 5th Super Tuesday) expect politics to receive a lot more focus form investors and market commentators in the week ahead. I won’t offer an election prediction but I am highly confident that you won’t hear anything new about market trends in election years than what I've written here.

Review of Recent Market Action

Periodically when the market is in an unusually volatile period I like to look at a performance of a wide variety of indices in order to see if there are any anomalies. This time I decided to look at the recovery off the August 16th intraday low. You will remember that was the day where the DJIA reversed a 350 point intraday loss to close down just 16 points. Overall, I don't see any trends in this data that would make me want to trade but there are some notable figures.

Since that time, most US market cap and style indices have recovered by a similar amount ranging from 7% to 9%. The NASDAQ and large cap growth, as measured by the iShares Russell 1000 Growth ETF (IWF) lead the way with recoveries of 9%. The Russell 2000 has been a laggard rising just 6.4% off its low. The worst recovery is in the Russell 2000 Value ETF (IWN) which has bounced just 5.4%. The heavy concentration of financials in IWN probably accounts for the weak recovery.

The divergences in performance have been greater when looking at returns in international indices. The EAFE has rebounded by 16% and emerging markets, as measured by the MSCI Emerging Markets ETF (EEM) has risen 23%. These two markets were the laggards form the July 19th highs to the August 16th lows so the outsized gains off the lows is not wholly unexpected. What might be surprising, however, is the fact that EEM is down just 2.6% since July 19th, the best performance/smallest loss of any of the indices I monitor. The DJIA, S&P 500, and NASDAQ are down from 4% to 4.5% since the high.

One other interesting return profile has been in Japan. As measured by EWJ in order to use prices during US trading on August 16th, the Japan has recovered 1.8% off its low. Using the Nikkei 225, Japan is down 11% from the July 19th high, the worst performance of any of the indices since that date.

Market Returns Since the All-Time Highs in July

The sell-off since the S&P 500 and Dow Jones Industrial Average made all-time closing highs on July 19th has been broad. All the major indices I track are down between 7% and 11%. I track these indices looking for divergences in returns that might be a clue to where leadership is emerging and whether prior leaders are turning to laggards. Given recent discussions on Wall Street about trends for large cap vs. small cap and growth vs. value, I thought a broad look returns since the market turned lower would be useful.

From the July 19th peak through the close on August 14th, the DJIA has fallen 6.9% making it the best performing major US index. The S&P 500 and NASDAQ are down by 8.1%, while the S&P 400 Midcap has fallen 9.4%. Within the market cap indices, the Russell 2000 has been the worst performer, declining by 10.5%. I see little predictive value in these returns as they strike me to be consistent with expectations given the greater volatility of the Mid Cap and Russell indices.

Looking at style, using the Russell 1000 and 2000 Growth and Value ETFs, there has been a slight edge for growth. Large cap growth is down 7% vs. an 8.9% decline for large cap value. The discrepancy in returns is larger in small caps style indices. The Russell 2000 Growth is down 8.8% vs. an 11.3% decline for the Russell 2000 Value. I suspect the carnage in small cap financial stocks accounts for the lagging performance of small cap value.

International markets have suffered similarly to the US markets. Based on the ETFs, the EAFE is down 8.9% while emerging markets (EEM) are down 11%, quite similar to small cap US. Japan has held up better, with the Nikkei 225 falling just 7%, but Japan had lagged the US and Europe in the weeks prior to the July 19th peak.

Correction or Bear Market?

As usual, Ned Davis Research (NDR) has some interesting data on last week's sell-off in regards to answering the question whether we have entered a bear market. Defining a bear market as a 30% drop in the DJIA after 50 calendar days, a 13% decline in the DJAI over 145 calendar days, or a 30% drop in the Value Line Geometric Index, NDR calculates that there have been 33 bear markets since 1900. The average 5 day decline that began the bear market was 3% with a median decline of 2.3%.

Using February 20th as the peak for the DJIA, the first five days of the current decline cost the DJIA 4.5%. That decline was extended to 5.2% last Friday which was day 6 and I as I write this on Sunday night, the Nikkei is down 2% and the S&P 500 futures are down 43 points. Only 6 of the 33 bear markets had a fist 5-day decline greater than the 4.5% decline we have experienced so far. In two other cases the first 5-day decline exceeded 4%.

Based on this data it would appear that bear markets normally do not start with a large swift decline so the folks at NDR decided to look at the number of 5-day declines that have occurred in past cyclical markets. Defining a bull market as the exact opposite of a bear market – a 30% rise in the DJIA over 50 calendar days, a 13% rise after 145 calendar days, or a 30% upward reversal in the Value Line Geometric Index – NDR calculates that there have been 33 cyclical bull markets since 1900. During these bull markets, there were an average of 5.1 five-day declines greater than 4% and a median of four such declines.

With history pointing to the fact that bear markets don’t usually start with a swift and severe decline, NDR decided to look at corrections in bull markets. Including the current decline, this bull market, which NDR dates from 10/16/02, has experienced 8 five-day declines of 4% of more. Of the previous 33 bull markets, only five had more five-day declines of 4% or more, while two others had eight declines. Interestingly of the five bull markets with more than eight 4% declines, three have occurred since 1987. It is probably fair suggest that this is an indication of increasing volatility over the past 20 years.

History is not necessarily a good guide but it does help to put large positive and negative short-term market swings into perspective. I have no idea whether we are starting a bear market or just enduring another swift and steep correction that appear to be becoming more commonplace over the past 20 years. However, if history is a guide and these sorts of measurements are a guide to a history, a swift decline like we are currently experiencing is more likely to be a correction than the start of a bear market.

One Reason The Market Has Done So Well

I am not a trader and Northlake's investment strategy is designed to outperform on a relative basis so whether the market goes up or down is a little less important to me than other money managers. However, that doesn’t mean that I am not amazed by the steady strength in the market since July. Steady adn strong are the operative words even though the absolute percentage gains have been large. Pullbacks have been minor and brief.

As I was driving the 465 miles home from Lake Superior to Chicago yesterday I was pondering the market and trying to get a better handle on what has been going on. When I pulled in for gas, a light went on. I know it is no surprise to anybody that oil and gas prices have collapsed but suddenly the impact on our collective pocketbook hit me. I paid $2.23 a gallon for gas down by over $1 per share from trips I took to Wisconsin in the past year. This trip is almost 1000 miles roundtrip, so at 20 miles a gallon in my 1992 Acura Vigor the savings is over $50. A commuter coming to downtown Chicago from some of the new suburbs might drive 60 miles roundtrip a day. That works out to a savings of over $60 per month. Small change to Wall Street tycoons maybe but real money in many checkbooks.....

When I got home I followed up by looking at our recent gas and electric bills vs. a year ago. I was shocked. In December 2006, our utility payment was down 23% producing a savings of $111. In January 2007 (I already received the bills), our payment was down 32% or $231!

There are about 110 million households in the United States. If just one quarter are saving a couple of hundred dollars per month in heating and gasoline, the savings are in the neighborhood of $5 billion. I know our economy is huge but that is real money. Maybe more importantly, it is real money in each individual household and that is good for sentiment towards the economy which impacts other spending.

I know there are offsets. In particular, the recent uptick in interest rates could impact tens of millions of adjustable rate mortgages. But given that the bear case for the last few months has revolved around a weakening U.S. economy, the savings in our energy consumption bills due to falling prices and a mild winter are a significant positive in the investment landscape.

Crisis Events Can Be Bullish Once They End

My pals at Ned Davis Research (NDR) provided a reminder about how the markets respond well to crisis events. I'm not sure the latest phase of the decline that began in mid-May was necessarily triggered by the Mideast crisis but I think the blow-up in Lebanon does qualify as a crisis event.

NDR has identified 41 crisis beginning with the closing of the Exchange during WWI. The crisis events range in length from days to months but most have been anywhere form one day to a few weeks. On average, during the crisis phase, the DJIUA fell 5.7% with a media decline of 2.9%. A large percentage of the crisis events were related to wars and other foreign incidents. About 1/3rd of the crisis events directly involve either the Mideast or terrorism. The most severe declines among those crisis events were the 1973 Oil Embargo (-18.5%), Iraq Invading Kuwait (-13.3%) and 9/11 (-14.3%). Several events inthis group led to little or no negative reaction including the 1983 Beirut bombing, the 1956 Suez Canal Crisis preceding the 1956 Arab-Israeli War, the U.S. bombing of Libya in 1986, the start of the Gulf War in 1991 and several of the "lesser" recent terror attacks like the USS Cole, the Bali nightclub, and the London Train bombings.

Of equal interest to the generally negative reaction to crisis events as they happen is that the associated market decline has historically put in a near-term bottom for stock prices.....

In the 22 days following the end of a crisis event, the DJIA gains an average of 4.2%, the 63 day average return is 5.2%, the 126 day average is 8.9%, and the 253 day average return is 14.9%. It is worth pointing out that the standard deviation around those averages looks pretty high to my eyeballs although the median returns are quite close to the averages.

So apparently, crisis events can be a positive catalyst. Whether the current situation in the Mid-East qualifies is open to be debate. And I think you have to say that the current crisis remains ongoing so the rally off Tuesday's may not qualify in the end as part of the post-crisis period.

Nevertheless, I think this data reminds us that it is always bleakest at the bottom. So resisting the urge to throw in the towel when the pain in your gut reaches a new intensity remains very good advice.

If you want a copy of the spreadsheet with the data on each crisis event, please email or comment below.

Does The Emerging Markets Sell-Off Indicate Their Run Is Over?

In a post yesterday on Real Money, my colleague Jim Cramer noted that despite massive sell-offs in equity markets in Brazil and India, he wasn't yet seeing any real weakness in the fundamentals for either economy. I think Jim's comments probably go beyond Brazil and India to include most other emerging markets.

Of course, a financial contagion could easily lead to deterioration in emerging market economies, so Jim's comments should probably include a big "so far" qualifier. Among other things, growth in these economies is being driven by cheap capital. Collapsing equity markets could halt or significantly raise the price of the capital inflow which undermines economic growth and recent currency strength (I still take comfort in the much more stable action in emerging market currencies relative to emerging market stocks).

My almost five year old position in Central European Media Enterprises (CETV) has led me to focus mostly on emerging markets in Central and Eastern Europe. These economies are being driven by low cost labor and infrastructure, increased political stability, new regulatory and legal laws, non-intrusive tax systems, and rapidly growing consumer economies. A stock market meltdown could undermine some of these trends but I think they will prove durable.

In support of Jim's contention that economic fundamentals look a lot better than recent stock market action, I pulled the following excerpts from a recap of an investment conference that Dragon Capital recently held for leading companies in Ukraine. Dragon is the largest broker in Ukraine according to their own press releases....

• Ukraine finished 2005 as Europe’s 12th largest and fastest growing market by car sales (25% y-o-y). Based on April statistics, the country advanced to ninth place. In 1Q06, domestic car output rose by 35% y-o-y, to 54,900. vehicles, and total car sales surged by 45% y-o-y, to 67,700 vehicles. Full-year car sales are projected at 330,000 vehicles. Russian VAZ, Ukrainian ZAZ and South Korean models (Daewoo and Chevrolet) remained the most popular car brands in Ukraine in 1Q06, accounting for 65% of new car sales over the period.

• Ukraine’s banking sector is among the fastest growing in Europe and is expected to catch up with Poland’s current market level in 5-6 years, implying an up to ten-fold consumer lending increase in the next five years. Ukraine’s mortgage market more than tripled in 2005, to USD 2.1 billion, growing by 140% p.a. in 2002-2005, driven by political stabilization, creation of a proper regulatory base, strong personal income growth (20% CAGR in 2004-05), real estate price growth (30-50% p.a. in 2004-2005), and declining mortgage interest rates (from 15.0% to nearly 12.0% in 2005) on higher competition and lower deposit rates.

• Despite robust lending growth, Khreschatyk (a leading bank in Ukraine) boasts outstanding loan portfolio quality and the sector lowest non-performing loan rate of just 0.3% of the 2005 loan portfolio

• Shostka expects its full-year sales to remain higher y-o-y. The company’s mid-term plans call for increasing semi-hard cheese production capacity by 40% in 2007-2008, introducing new higher margin semi-hard cheeses, and raising the volume and variety of small packs sold, to be supported by a nationwide advertising/brand-building campaign.

• With Ukraine’s total advertising market forecast to grow from just over USD 500 mil. in 2005 to about USD 1.2 billion in 2008, KP Media plans to accelerate its growth by aggressively expanding regionally with existing titles and launching new publications in order to solidify its leading market position. The company also plans to offer new web resources to extend its reach for the Internet audience.

• Sablink is looking to raise USD 48 million to acquire 600 ha of agricultural land within 18 km of the Kyiv city. Upon the purchase and conversion of the land to a residential construction site, the transaction manager will either sell it to property developing companies to exploit “conversion arbitrage” or will hire property developers to build a suburban cottage village and capitalize on growing demand for out-of-city houses.

• Modeled after VK’s existing successful malls, the development company plans to build over 230,000 square meters of modern shopping and entertainment space in eight locations over 2006-2008. VK’s supermarkets and hypermarkets are expected to be the malls’ key anchor tenants, while competing for properties and leasing them at market rates.

• MTI is Ukraine’s leading shoe retailer and exclusive domestic distributor of international brands such as Ecco, Lloyd, Clarks, Bally, Camel Active and many others. The company operated 37 shoe stores and three luxury menswear stores (Ermenegildo Zegna) nationwide as of May 2006.

I suspect that similar comments could be found about many emerging markets. The point is not to downplay the ramifications of the recent collapse in many emerging market stock indices. Rather, it is a reminder that sometimes stock prices do their own thing and that a financial panic doesn't always lead to an economic shock.

Catching Up on Recent News

Sorry for the lack of posts recently but there has been lots of news on stocks of interest to Northlake clients that has occupied my time. Here's a brief recap:

NTL, Incorporated: Northlake clients own NTL Warrants that expire in 2011. A few clients also own NTL common shares. NTL recently announced the sale of its broadcast tower business for a better than expected price of $2.5 billion. The company has not yet announced how it will use the proceeds but I expect a significant portion to be returned to shareholders via a one-time dividend or share buyback. Debt reduction or financing for a merger with Telewest, the UK's other major cable company, could also consume cash. Any of those events is positive for the stock. NTLI shares are very inexpensive at just 10 times 2005 estimated free cash flow. If the company hits its earnings and subscriber targets the next several quarters, a price target of over $90 is quite realistic.

Central European Media Enterprises: CETV is a long-time Northlake favorite. CETV owns TV stations in Slovenia, Slovakia, Romania, and Ukraine. Northlake clients recently sold their CETV holdings for a small loss. The sale was completed because 20% of current business is in Ukraine which faces challenges in the current quarter due to the political turmoil. Unfortunately, the sale was completed before CETV announced on Monday that it was making a major acquisition of the leading TV station in the Czech Republic. The shares responded very positively, gaining almost $6. While I am disappointed to miss the gain, I am strongly considering repurchasing CETV as the acquisition increased the 2005 and 2006 upside. I think the $6 rise was a little too much and look to repurchase the shares in the $35 range all else equal. If CETV hits our expectations in 2005 and 2006, a realistic price target is in the $50s.

Motorola has been in the news recently due to the Sprint-Nextel merger. MOT is the sole supplier of phones and network infrastructure to Nextel. MOT shares fell sharply late last week on fears the business would be lost. Northlake took advantage of the weakness, adding MOT to new client portfolios or increasing positions in select client accounts. Northlake believes the turnaround at MOT is real. Furthermore, today Sprint and Nextel announced that MOT will be a significant supplier to the new company in the transition of Nextel's network to Sprint's technology. Additionally, Nextel announced it would be a long transition, which means that MOT will not lose the business in the near future. This should clear the way for MOT to meet our $22-24 price target assuming the company performs as expected in the important Christmas selling season.

SBS Broadcasting shares have been weak lately and have largely sat out the market rally. This is surprising given the solid third quarter earnings report issued in November and the significant financial benefit the company gains from strength in the Euro. Northlake's spreadsheet reveals that SBTV shares are valued at less than 7 times 2005 estimated cash flow, a sharp discount to comparable European and American TV and radio broadcasters. An expansion in the trading multiple to just 8 times 2005 estimated cash flow (still a large discount to its peers) would move the shares into the mid $40s. Northlake is using the weakness in SBTV shares to add positions for new clients and expand holdings for selected clients.

KMart was added to client accounts several weeks ago after the euphoric reaction to the Sears merger was reversed. While Northlake does not believe the long-term future of the new company is attractive, in the short-term the shares will be driven by restructuring actions and realignment of the company's vast real estate holdings. The investment horizon on KMRT is 3 to 6 months with a target in $120 range or higher. Announcements of restructuring and real estate actions are expected after the Christmas selling season is complete and should be the catalyst to move the shares higher. Initial client positions were small and undertaken with a willingness to purchase more shares if the stock fell toward its technical support at $92.

Market Fades

As outlined in recent posts, we expected the weakness experienced by the market the last few days. Besides the poor corporate earnings, which was the catalyst we expected would cause a pullback, oil prices have spiked up again to their recent highs. High energy prices are actually part of our thesis for expecting weak earnings, as margins are being squeezed....

However, high energy prices also put a damper on consumer spending as cash is diverted to gasoline or home heating and cooling and away from discretionary spending. The cash level in Northlake's model portfolio remains at 13%. We intend to give this current phase a bit more time before looking for a point to reinvest.

Fed As Expected

The Fed raised rates 25 basis points and kept its commentary relatively unchanged. The market responded with a small rally. The focus will now shift back to earnings, which we expect to kick off a pullback in stock prices. Oil as moved up to its highest levle in about a month which also presents a short-term headwind. Wednesday monring saw poor earnings from Morgan Stanley and lower guidance from Wendy's, continuing the bad earnings news so far this week. No change to our cautious short-term outlook and cash levels in our model portfolio remain at their highest levels since Northlake opened in June.

Monday's Action

The Dow and S&P were weak on Monday in the face of earnings warnings from Colgate Palmolive, New York Times, and PMC Sierra. Colgate fell 11%, NY Times fell 2%, but PMC actually rose 4% and kicked off a rally in the NASDAQ led by semiconductor stocks. The NASDAQ rally was a surprise but doesn't change Northlake's expecation for near-term weakness....

As we have written, there appears no doubt that 3Q earnings will be weak in light of weaker economic activity over the summer. However, the stock market reaction is contingent on what is already embedded in prices. Nearly everyone expects weak earnings, so the possbility exists that bad news will not be greeted by lower prices.

Yesterday's reaction in PMC Sierra shares is a good example as semiconductor stocks have been the worst performers the last few months, thus bad news was greeted with a sigh of relief that it wasn't even worse. The NASDAQ has a lot of overhead resistance and most tech stocks are rallying into declining trend lines so we do not expect much further upside without a strong upside breakout on heavy volume that clearly reverses the trend.

As we await the Fed meeting beginning today, we expect more bad earnings news from non-tech companies will ultimately be the arbiter of the broad market direction. We expect that to be lower over the next few weeks. Consequently, we have raised cash in the model portfolio to its highest point since Northlake was established in June 2004.

Stock Market Seasonality

Lehman Brothers had some interesting research out this morning regarding the seasonality of stock prices as it relates to the third and fourth quarters and election years. This research supports our view posted earlier today of near-term caution followed by year end strength....

Quoting Lehman Brothers:

US equity returns show clear seasonality. Since 1965 Q3 has been the worst average performer (-1.6%) while Q4 has been the best (+3.9%). Year-end rallies have also been relatively consistent. There have been 3 times as many up years than down quarters in Q4. In recent years the trend has become more pronounced, Q4 returns have exceeded average Q1-Q3 returns in the last 5 out of 6 years. As possible causes of seasonality, earnings and fund flow trends offer little reason to think that 2004 will not see similar Q4 strength. Moreover, since 1900, US election years have on average boosted H2 performance strongly.

This statistical data is being fairly widely discussed on the Street, which means it may already be reflected in stock prices. However, we believe weakness in the remainder of the third quarter and early fourth quarter is probable as earnings are likely to disappoint even lowered expectations currently in place.

A Little Cautious

The market enters the second half of September near its recent highs after a strong rally off the early August lows. Northlake's recommended stocks and models have performed well in the rally but we are beginning to take a more cautious view. Quarterly earnings season is about to start and...

...we believe the possibility of a repeat of July's market weakness is possible. It is now clear that the economy has slowed from the rapid growth of late 2003 and early 2004. Slower growth first impacted corporate earnings at mid-year as 2Q earnings results and guidance were below expectations. We expect another bout of weak reports and poor outlooks in 3Q reports. The big question is whether this news is already baked into stock prices. In July, the bad corporate earnings news was largely unexpected and the slowdown in economic activity caught corporate managers and Wall Street by surprise. Stock prices responded by moving sharply lower. Most commentators are expecting a weak earnings season now so stock prices likely reflect some of the upcoming negative news.

Northlake believes that the rally in stocks leaves the market vulnerable to upcoming news flow and the possiblity of a 3-5% pullback is high. We expect stock prices to be above current levels by year end, however. Consequently, we will use any pullback to position portfolios in our favorite stocks and invest cash reserves.

Later in the week, we will provide updates on recent performance and news from our special situation portfolio. In the meantime, you can find a summary of our thoughts on our portfolio on the Research Samples link.