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As expected, Federal Reserve official left interest rates unchanged when they met this week. With only two meetings left this year (Oct. 24-25 and Dec. 12) it appears likely that we might not see another increase in 2006. Combined with some fairly powerful fundamental economic factors, it appears that conditions are ideal for stock markets to stage a nice advance through the end of this year.

After a fairly major correction that began in May, major stock indices began advancing again in August as traders and investors anticipated that the Fed was nearing a pause after 17 consecutive rate hikes. I have a high level of confidence that the rest of this year provides one of the best investment opportunities we’ve seen this century. I’ll detail some of the reasons below, but take a look at the following chart.

The black line is the S&P 500 and the gold line is the Nasdaq. Notice than since the start of 2004 the S&P has been in a gradual upward trend. The Nasdaq has been more volatile and has only advanced about 5% during that time. The blue line is a 200-day moving average. You can see that the S&P crossed back above that average a few weeks ago. The correction that occurred this summer was fairly significant–one of the worst in the past five years. It turned a lot of investors and managers bearish, but I think fundamental and technical conditions no favor the bulls.

The bottom section of the chart above is the P/E Ratio of the S&P 500. This widely watched indicator is at its lowest level in the past five years. There are still plenty of experts who will argue that stocks remain overvalued. Whether that is true or not, they are obviously less overvalued than they have been for many years.

Business is generally good. For the first two quarters in 2006, most businesses reported quarterly earnings that were ahead of expectations. That should continue as third-quarter results start coming in in early October.

Unemployment levels are below 5%. That happens to be the level that many economists believes marks full employment. In many areas, employers are struggling to fill industrial and manufacturing positions that traditionally never go unfilled.

GDP remains positive, but is not so strong that the Fed will feel obligated to continue raising interest rates.

Ditto for inflation. It is still there, but doesn’t seem to pose an immediate threat.

We are only a couple of weeks away from the start of the extended Christmas shopping season. Consumer spending over the next three months will provide a substantial boost to the retail economy.

Oil prices are dropping, leaving more money in consumer pockets for holiday spending.

In addition to these fundamental reasons for the market to keep advancing, right now just about any technical indicator you can think of is also positive. I’m not convinced we will see a major rally that will add 20% or more before the end of the year. But I do think all the major indices will end 2006 in the black and at multi-year highs.

Energy funds weakening as price of oil falls

I don’t normally like it when fund charts look like the one below. But in this instance, I’m thrilled. The chart shows the performance of Select Sector SPDR - Energy (XLE) and it is fairly typical of most energy and natural resource funds right now. The gold line is a 200-day moving average and the chart shows that after trending well above that line for the past two years, the fund price is finally falling. Naturally this move is directly correlated to the falling price of crude oil on world markets.
 
 

If this move continues, it will only mean good things for the overall economy. It will provide a major relief to inflationary pressures and give consumers a little bit of breathing room. High oil prices tend to have a dampening effect across the economy. They impact virtually every business and consumer. So after several years of watching these funds advance, its nice to finally see some signs of weakness.

I know I personally felt a little relief today when I filled up my diesel pickup and paid $3.09 a gallon. For many of you that still sounds like a high price, but a month ago I paid $3.60.

I hope the first weekend of the fall season is wonderful for you. I’m looking forward to some college football and some cool weather.

F.S.

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