NOLTE NOTES
Jittery Markets
by Paul J. Nolte, CFA
May 17, 2004

The equity markets started the week right where they left of the prior week � on a big-time downer. In fact, the advance/decline ratio for both of those days (May 7 & 10) were at levels not seen since the crash of 1987. What was missing was very high volume, indicating capitulation. While the economic numbers remain good, inflation seems to be creeping back into view. While we have long suspected an inflationary cycle (see the rise in commodity prices over the past two years) the government has not yet recognized that it costs more for nearly everything we buy. The coming week sees little in the way of economic reports and a few company earnings, so it will be trading off of rumors and innuendo. We may actually get to see the true character of the market during the week. The markets have been fixated on interest rates and the oil markets for the past month. Rates have increased by 1 full percentage point and everyone is left wondering when the Fed will get on board. While rates actually finished little changed on the week, oil prices continued their trek into �highs unseen since� territory. We have eliminated the high yield component of income portfolios, as a combination of flight to safety and poor equity markets are conspiring to widen spreads between high yield and government bonds. While the equity markets may be volatile next week, we do expect some return to �normal� that may allow us to further reduce equity exposure.

Many of the shorter-term indicators are at lows not seen since the lows in July �02 and March �03. The one missing component, as alluded to above, is volume. Unlike the prior bottoms, volume levels were at least 40% above prior two-week levels. The sell-off only made it to 17%, well below �panic� levels. We have harped upon the fact that money is no longer flowing to equities, as an easy money interest rate environment is coming to a close and taxes are not likely to be cut again. One other nail in the coffin is money flowing into or out of equity funds. Equity funds, during the first four months of �04 were on par with the record flows of �02. Yet, for all the money coming in, the markets could not make meaningful headway. That too, according to Trim Tabs (who tracks this sort of thing), is ending, as investors PULLED money from equity funds. None of these are �aha� points that one can say is the reason for a lousy market, but it is part of the evolving mosaic that is coloring a darker background for the equity markets. Over the very short-term (next week or two) the markets may actually rise, as investors have done a fair bit of selling recently. But look for selling to resume after Memorial weekend.

The rapid rise in rates, like the equity decline, may have come to an end. The rise in rates has been moving in lock step with the rise in oil prices over the past two weeks with few breaks. Friday, however, investors figured rates started looking pretty good and bought. The bond model moved up one notch, but still negative at 1/5 (need 3/5 to be positive). We believe the bond market is the last market to �top�, as equities topped in �02 and commodity prices bottomed also in �02. The markets may be experiencing a long-term trend change from rising to falling.

The group work is getting interesting. We try to tell the tale using the groups for assistance, and we are at a point that may contradict all the elegant prose above. The financial sector has taken it on the chin over the past few months, as REIT have succumbed to higher rates, banking and brokerage stocks have also suffered the same fate. However, this week saw a large amount of reversals in the financial sector. We are generally looking for a few criterion to be met: highs and lows both higher and lower than prior week, and a close in the top 20% of the weekly trading range, with volume better than the last two week average. Finally, the stocks needed to have been poor performers up to that point. Lehman (LEH) and Merrill Lynch (MER) in the brokerage, at least five of the banking issues and a utility issue for good luck all exhibited a reversal last week. When the market bottomed formed in March �03, we saw some of the same characteristics from these stocks. However, unlike �03, the carnage has been merely two months and not two years. As a result, we don't expect the same type of long-term outperformance, but maybe just a few weeks. The markets, as indicated above, have been very sensitive to energy prices, and it should come as no surprise that the energy complex is near the top in performance. The only holdout are the drillers, even though drilling activity remains at high levels. Our investment focus has been in the �majors�, investing in Exxon-Mobil (XOM) and Chevron-Texaco (CVX) as well as the energy Exchange Traded Fund (XLE). We will be adding to positions in this sector, as long as prices remain firm.

The markets remain jittery and have been trading off of energy prices and interest rates. We have eliminated our exposure in high yield, as this equity like bond investment has turned lower and is likely to underperform short-term bonds in the future. We have also reduced some of our small-cap exposure and will raise additional cash over the days/weeks ahead as opportunities to do so present themselves. Our stance toward the markets remain cautious, however investments in food and energy issues should do relatively well in this environment. If we get any further rally in financials, we may cut our under weighted position further.

© 2004 Paul J. Nolte, CFA
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The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

Contact Information
Paul J. Nolte, CFA
Director Investments
Hinsdale Associates
630-325-7100
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