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Now that most of the evidence points to a slowing economy, many analysts and market watchers are questioning whether or not the Federal Reserve is going to be able to orchestrate a “soft landing.” It is a valid concern, but it is probably too early to worry about it.

As I’ve noted several times in the past, even Federal Reserve officials know the Fed has historically been bad at orchestrating such soft landings. The typical pattern is for the Fed to slow the economy too much and push it into a recession. This occurs because there is a lag between the time the Fed raises interest rates and when those rate hikes are felt in the economy. That lag will usually be six to nine months at least. In other words, although the Federal Reserve elected not to raise interest rates in August, the economy is probably not going to feel the full impact of the prior 17 rate hikes until late winter or early spring in 2007.

Regardless of what the stock market picture will be like in six months or a year, right now it is looking pretty good. Obviously there is always a possibility that conditions could change, but for the past few weeks the markets have been moving up nicely. Over the past two months, more than two-thirds of all exchange-traded funds have positive returns.

Here’s a chart to show you the situation.

The black line on the top portion of the chart is the daily price activity of the Nasdaq. Since bottoming in mid-July, the index has advanced nicely and is up more than 7% from its low. The wavy blue line is a 50-day moving average and the Nasdaq is now well above that line. The gold line is the S&P 500. It is also in a nice uptrend. The bottom three windows on the chart are different technical indicators: a Moving Average Convergence Divergence (MACD), relative strength index, and momentum. All are positive and typical for an index that is in a bullish trend.

The green line on the chart is one I added. It shows the slope of the current Nasdaq rally. If one were to extend that line for a few months and the Nasdaq continued its advance, the index would be back to its prior April high sometime in November. That would set up a run for a new high before the end of the year. In 1992, 1993, 1995, 1996,1997, 1998, 1999, 2003, 2004 and 2005 the major stock indices reached their yearly peaks in December. That’s not a coincidence. Every money manager and Wall Street trader wants that last statement of the year to show the highest number possible. The Dow and the S&P 500 are only a couple percentage points from their prior highs of 2006. The Nasdaq needs to gain about 8% to reach a new high for the year. Economic fundamentals are still strong enough that we are likely to see the indices peak sometime close to the end of the year.

There are still some respected market analysts who are urging caution because of the market’s tendency for major meltdowns in September and October. But there have also been years when those months produced significant gains. All we can really do is take what the market gives and right now it seems to be setting up for a nice run in the latter part of the year.

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We’ve all heard stories about an investor who bought the right stock at the right time and made enormous profits in just a few weeks or months. Such instances are rare. That is why they attract attention. But novice investors hear these stories about fast fortunes and mistakenly expect that quick gains are the norm and not the exception.

A couple of weeks ago I noted that the Nasdaq is currently trading at about the same level as it was at the beginning of 2004. In other words, investors who purchased an OTC Index fund at the end of 2003 have seen no increase in their account value. But wait, it gets worse. An investor who purchased the same fund at the start of 2000 saw his investment decline by almost 75%. That same account has now recovered about half of its value. But an investor who started with $100,000 in that index fund in 2000 still only has about $50,000 in that account today.

Major bear markets are the reason buy-and-hold investing is not a viable strategy for most investors. If one buys at the wrong time the impact on an account can be devastating. If one is forced to cash out during a bear cycle, the impact could conceivably reverberate through a family for generations. As a result of the bear market that began in 2000, I personally know several people who suffered terrible losses in their retirement savings. Some of them had to delay retirement and others had to return to work.

At Strategis Financial Group, we espouse a philosophy of active risk management. The concept is simple. We try to lessen portfolio risk by choosing investments that are in strong uptrends. During periods of market weakness, we try to move those positions to cash or to hedge them with offsetting short positions. The actual application of the concept is very complex and fraught with uncertainty. It also requires some long-term commitment. We normally advise investors that it can take up to five years to experience the benefits of a strong bull cycle. The last one occurred in 2003.

Perhaps I can explain it best with an analogy about fishing. When I am planning a fishing trip, I do everything I can beforehand to improve my chances for success. If it is a new water, I study the kinds of fish that live there. I research the topography and habitat. I try to learn what methods have been used successfully there in the past. When possible, I talk to people who have fished there recently to get up-to-date reports. As the date approaches, I check moon cycles and watch weather reports.

All these preparations increase the chance for a successful trip, but they do not guarantee it. There are too many uncontrolled variables. For example, I once scheduled a trip to Canada in early August. Usually that is a prime time for fishing. This was a backpacking trip so weight was a consideration. We limited the amount of food we took, because we thought we could supplement our meals with fish. Unfortunately, an unexpected cold front struck on the day we arrived. Nighttime temperatures were below freezing and the fish completely stopped feeding. That meant we did too. We were very hungry for several days.

On a different trip this spring trouble with the boat’s engine and high wind forced us to fish from shore in protected coves. We caught fish, but not nearly as many as anticipated. A few weeks ago on a trip to Lake Powell we experienced incredible fishing where we caught a fish on virtually every cast. They were 1-year-old fish only about 12 inches long. But they were so prolific that we could rarely get our baits past them to the deeper water and bigger fish we were really seeking.

Sometimes investors mistakenly believe that the term “active risk management” means that an account will be traded frequently. That is usually not the case. Usually trades only occur when market risk appears to be high or when an investment fails to perform as expected. Going back to the fishing analogy, an angler isn’t usually going to move to a new spot if he is already catching fish.

Once in a while, the forces of nature seem to combine to produce a fantastic fishing trip. The weather will be beautiful and the fish will bite non-stop. Like an investment that doubles in six months, these types of fishing trips don’t occur very often. But one such trip is often enough to give a fisherman hope for many years.

Since the start of 2004, market conditions have made it difficult for investors to make any profits. Trading ranges have been narrow and there have been no long-term trends. If the market can somehow advance through the end of this year, it would provide the best profit opportunity since 2003. For the past couple of weeks, market internals improved and technical and fundamental indicators have largely turned positive. If we can get another short-cycle advance in the next week or two, it could provide a foundation for the strongest market rally we’ve seen in quite a while.

Keep your fingers crossed.

A week ago, I stated my opinion that U.S. stocks were on the verge of a rally. Major stock indices have been rising ever since. I guess we all get lucky from time to time. Now I must warn that stocks are unlikely to continue rising at this pace for much longer. That doesn’t mean we are going to see a major correction. I just expect that a continued advance will be more measured.

As a mentioned last week as well, this correction has been much more serious for the Nasdaq than for blue chip indices. The chart below paints a clear picture. The black line is the Nasdaq and the gold line is the Dow. You can see that the Dow has recovered most of what it lost during this correction and is back to its level of lat April and early May. Another good week like we’ve just had would have it back at its May high.

The Nasdaq still has a long ways to go by comparison. This week’s rally has been nice, but the Nasdaq hasn’t even made it back to its July high, let alone the highs reached in April and May.

In the midst of this correction, I wrote that the sectors and funds that were doing the best before the fall would likely be the quickest to regain leadership when the market recovered. That has also proven to be prophetic. Since the major indices bottomed the fastest rising sectors have been emerging market funds–market leaders for much of the past three years. The technology sector is also improving. Technology stocks tend to move strongly at the beginning of major market rallies, so the re-emergence of tech funds near the tops of the recent rankings is a good sign.

The chart below illustrates the situation. The black line is iShares MSCI - Mexico Index Fund (EWW). Since June 16, this fund has risen 22.5%. The red line is iShares MSCI - Emerging Markets Index Fund (EEM), up 11.79%. While both corrected sharply in May, they bottomed in mid-June and have made strong recoveries since. Other Latin American and emerging markets funds have performed equally well.

The technology funds have really come on strong in the past month. The blue line is iShares Goldman Sachs Semiconductor Index Fund (IGW). Since July 14 it has risen 10.51%. The gold line is Merrill Lynch Software HOLDRS Dep Receipt (SWH). It is up 11.01% over the same period.

Asian and Pacific Rim funds are also doing quite well right now.

As long as the market continues to advance, these sectors are likely to be near the top of the rankings. As the rally gains momentum, other industry sectors will begin to participate. Since 2003, we have not seen a market rally that endured for more than a few weeks. Perhpas if the Federal Reserve can keep from raising interest rates the rest of the year we could see a longer advance carrying the markets into the early part of 2007. Keep your fingers crossed!

The first of 17 consecutive Federal Reserve interest rate hikes began June 30, 2004. So Tuesday’s decision to not raise rates came a little more than two years later. The day the rate hikes began, the Nasdaq closed at 2048. After Tuesday’s announcement, the Nasdaq ended trading at 2061. In other words, in the ensuing two-plus years, the Nasdaq essentially made no progress.

There certainly has been volatility during the past two years. But much of it has been confined to choppy, daily price movements within fairly tight ranges. Long trends have been non-existent.

Below is a chart that will help you see the situation more clearly. The black line shows the daily price movement. The red line marks the level of the Nasdaq when the Federal Reserve began raising interest rates two years ago. The green line is a support line. I believe it gives a clue about where the Nasdaq could be headed.

First I need to emphasize that I do not claim any special ability to forecast market movement and I don’t believe anyone else has that ability, either. The investment markets are influenced by so many fundamental and technical variables that it is impossible to account for the potential impact of every one. I do, however, believe that by carefully assessing fundamental, technical and cyclical factors it is possible to identify periods when market risk might be higher or lower than normal.

After throwing out a couple of cautions, I’m going to detail why I think the Nasdaq is likely to soon stage a rebound. The first caution is a seasonality issue. September is the weakest month of the year for market returns going back to 1926. It is the only month where the S&P 500 averages a negative return. October is the next weakest month, although it averages a gain of about a half percent. Certainly there is no guarantee that stocks will lose month over the next two months. But neither should this tendency be ignored.

The second caution is the political situation in the Middle East and already record oil prices. A single, unforeseen event could easily drive oil prices above $100 a barrel in just a day or two. That would sent stocks plunging and push the world economy to the brink of recession.

Now for the positive view.

• The economy remains strong. Although preliminary second quarter GDP figures showed a sharp decline from the first quarter, the 2.5% annualized rate is more in line with what the Federal Reserve wants.
• The Fed chose not to raise interest rates for an 18th consecutive session. The markets initially sold off on the news that Fed official were holding the line. While this might not be the end of rate hikes, additional increases will likely be few and far between.
• The overall economic picture isn’t too bad. Unemployment remains low. Corporate earnings for the prior quarter have generally been better than expected. By historical standards, mortgage rates are still low and the housing market has slowed but not collapsed.
• The current correction is already the steepest in two years. Now in its fourth month, the market seems to be forming a bottom. Unless this is going to turn into a massive correction, downside risk should be minimal and certainly less than it was four months ago.
• Seasonality again. The three strongest consecutive months for the broad market are November, December and January. If stocks can hold ground for a few more weeks, seasonal momentum should kick in.
• The S&P 500 and the Dow are both showing strength. Each is trending above 50 and 200-day moving averages and the Moving Average Convergence Divergence (MACD) for each is positive. Neither corrected as sharply as the Nasdaq and both have made substantial recoveries.
• The chart above. While the Nasdaq broke through support from the rising green trendline, it found support at the 2050 level marked by the red line. I expect it to bounce from this level back to the area of its most recent high at about 2300. That could happen in just a couple of weeks or it might take until the end of the year. And while the MACD for the Nasdaq is still negative, it is moving up and could quickly turn positive.
• When assessing overall market health, I like to look at the universe of Exchange-Traded Funds (ETFs) because they include virtually every market and industry sector. There are currently just over 300 ETFs. Over the past 30 days, half have had positive returns. That is much better than a few weeks earlier.

That’s how I see things right now. I don’t discount the possibility that the market could tumble again from here. I just think there are more reasons for it to go up than down.

I hope you all have a great weekend.

Major stock indices have failed to find a trend in the past few sessions. There has been lots of up one day and down the next. With the next regularly scheduled meeting of the Federal Open Market Committee on Aug. 8, expect more of the same until then. Traders and investors were hoping that this would be the meeting where the Fed announced that it is done raising interest rates for a season. But recent economic reports have raised a dilemma: Although economic growth is slowing, inflation continues to rise.

Second quarter GDP was 2.5%, according to last week’s report. That compares to 5.6% in the first quarter. That was a much lower number than economists predicted. So it would appear the Fed’s attempts to slow the economy by raising interest rates is having the desired effect. Not so fast. According to the Bureau of Labor Statistics (www.bls.gov), inflation grew at 5.1% in the second quarter. That compares to a 3.4% annual rate in 2005.

Because the Fed’s primary objective is to control inflation, another rate hike appears likely. Historically the pattern has been for the Fed to continue raising rates too much and too long, eventually pushing the economy into recession. These latest reports provide ample ammunition for the Fed to keep the pattern in place.

How will Wall Street react if the Fed raises rates again? We won’t know for sure until next week, but it will be difficult to sustain a market advance if traders believe a recession is on the horizon.

An international view

I get frequent questions about investing in international positions. Usually the queries are prompted by poor performance by the U.S. markets. While investing internationally has some benefits, it can also pose real perils.

International investing adds a currency component that can enhance potential reward but also increases risk. During portions of my life I’ve spent significant periods overseas, mostly in Europe. Here in the U.S. we usually pay little attention to currency fluctuations. That isn’t true elsewhere. In many countries, changes in exchange rates will have clerks busily repricing all the goods on store shelves. A few pennies difference in the exchange rate can be magnified many times in other parts of the world.

International markets are also influenced by the same fundamental factors that impact the U.S. In recent months, that has included things like higher energy prices, interest rates and inflation. In general, countries with abundant natural resources like oil or precious metals have prospered. Countries forced to buy those goods on the world markets have struggled.

Here is the overriding caveat of international investing: The United States is the world’s dominant customer. U.S. consumption is the engine that drives world markets. As long as the U.S. economy is doing well, other world markets are also going to advance–some of them at a faster pace than the U.S. But when the U.S. economy stalls, it is difficult for any market in the world to significantly advance.

Weakness of the U.S. dollar has been a common theme of investment gurus for a couple of years. But a weak dollar is not necessarily a bad thing. A weak dollar helps make many U.S. companies more competitive and U.S. goods more attractive. It boosts tourism to the U.S. And it helps those international funds earn higher returns.

Below is a chart of ProFunds Rising Dollar Fund (RDPIX). This fund mirrors the U.S. Dollar Index (USDX). The gold line is the S&P 500. Notice that neither the dollar nor the S&P 500 have shown much of a trend over the past year. Notice also that the two are generally inversely correlated. In other words, when the dollar falls, the stock market advances. The bottom portion of the chart is a relative strength index of RDPIX.

While these positions appear choppy and volatile on this chart, that is a little deceptive. When you look at the scale on the chart, you see that both of these positions traded within about a 12% range over the past year. For comparison, look at the chart below.

The blue line is RDPIX. The gold line is iShares MSCI - Brazil Index Fund (EWZ), a fund we wrote about quite often during the past year. The black line is EUROX, a fund that invests in companies in Eastern Europe. I hold a position in that fund. The trading range of these two funds over the past year is nearly 80%. Compared to these two funds, RDPIX is relatively tame.

EWZ and EUROX are both considered emerging market funds. That means they focus on companies in parts of the world where markets are still developing. That means companies in those regions have an opportunity for accelerated growth. Emerging market funds tend to be among the most volatile of international funds. When things are good, these funds can make money quickly. But they can lose it even faster when the economy falters. They are not generally suited for conservative investors or only as a very small percentage of one’s overall portfolio.

As long as the U.S. economy continues to grow, most international funds will continue to do well, as they have over the past couple of years. But good things don’t last forever and the run of dominance by international funds will end if we see the U.S. economy move closer to recession. In the meantime, if you choose to dabble in international funds, you might not want to leave this country for an extended vacation.