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Stocks in a Soft Patch or Bull Market?

Through the end of last week, for every two stocks that were up this year, there were another three that were down. Among the major companies in the most popular market proxy, the S&P 500 Index ($INX), 213 were up for the year, while 287 had fallen.

These stats may seem unexceptional when you consider the S&P 500 is down 4.3% in 2004, but it's relevant because it helps us understand whether stocks today are merely in a soft patch of a bull market that started in spring 2003 or have actually resumed the great millennial bear market.

The latter is probably the case, unfortunately. But before holding a wake for stocks, let's back up a moment and see how we got into this mess.

Three weeks ago in this space, I reported that the broad market's behavior through the end of the third week of July would likely provide a strong signal for its direction the rest of the summer and fall. At the time, the S&P 500 and Dow Jones Industrial Average ($INDU) happened to be resting just below their 200-day moving averages, the traditional dividing line between intermediate-term bull and bear markets. They were also sitting just above their 200-week moving averages, a traditional dividing line between longer-term bull and bear markets. There was still a chance that low prices would generate enough buying enthusiasm among investors to push the indexes back into bull territory.

Running out of ammo

When higher crude oil prices two weeks ago and lower national job-growth figures last week both conspired to dent shareholders' faith in the potential for stronger second-half economic growth, however, investors unloaded a lot more stocks than they bought. And that selling shoved the indexes well below both their 200-day and 200-week moving averages into bear territory.

Many big players in the market, such as long-only mutual funds, love to see a high-volume breakdown like that, as they believe panicky selling gives them a chance to buy great stocks cheaply. But other big players, such as opportunistic hedge funds, are trend followers, and will see a major breakdown like the one that occurred last week as an opportunity to make money by pushing stocks even lower.

The winner in the battle behind reversal-players and trend-players is very often the one with the most ammunition. And at this point, you'd have to give the bears the edge as mutual fund inflows in the past two weeks have turned into outflows -- potentially depriving bulls of the ammo they need to send prices higher. Mutual funds are fully invested most of the time, so when the public starts pulling money out, their managers are forced to sell stocks to meet the redemption requests even if they are personally bullish. This selling leads to more selling, and the rout is on.

Focusing on fundamentals

Of course, all this talk of indexes and averages can get pretty boring, and even useless, without an understanding of both the fundamental backdrop as well as the action of individual stocks. Let's take the first one first.

It's tempting to look at certain improving fundamental yardsticks and say that stocks are probably cheap enough to spur buying. After all, interest rates are still pretty low, and companies generally are getting more productivity out of fewer workers -- making them stronger financially. Economists at ISI Group estimate that the S&P 500 stocks on average are selling for 15 times next year's earnings, which is fairly reasonable. And corporate cash hoards are near record highs.

But all of these metrics are "coincidental," in the parlance of economists -- meaning that they tell you something about what's happening now, but not much about the future. To peer beyond the horizon, you need non-linear measurements that bend around the corner and don't just extrapolate the present forward. That's where the work of Lakshman Achuthan at the Economic Cycle Research Institute comes in handy. As I've reported all year, his weekly leading index -- which compacts a variety of predictive economic indicators into a single number -- has continued to point down in an increasingly persistent, profound and pervasive way despite rosy reports out of Washington. Achuthan's analysis suggests that U.S. economic growth is distinctly slowing from the above-average pace of last year.

Late last week, he reported that although all of his global coincident economic-activity indexes remain in cyclical up-trends, all long-leading regional indexes have turned down. He said coincident indexes are likely to follow suit and noted that there has historically been a one-to-one correspondence between growth-rate cycles and stock price cycles, especially in the United States. Here's the sequence: Normally the earliest indication of a coming downturn in the U.S. growth rate comes from a downturn in the long-leading index. Then there's a downturn in U.S. stock prices. And only after that does actual economic growth turn down. In the current cycle, the long-leading index peaked in July 2003 and stock prices followed early this year.

Looking for bargains

So what about individual stocks? It's useful to look at the action of institutional favorites at times like this. If there really is a growing interest in buying bargains, there is a relatively short list of large and small chestnuts that the growth crowd always likes to buy on big dips.

It's pretty hard to have a bull market when growth stocks, which people buy when they're optimistic about the future, are losing ground and defensive stocks, which people buy when they're pessimistic, are taking their place. So with the fundamental picture clouding up and the technical picture already stormy, it's hard to be sanguine about the prospect for a rebound.