I’m a little distracted today because my youngest daughter is getting married Saturday. Thankfully, the markets are pretty much in a holding pattern right now and there isn’t a lot to write about that I haven’t addressed in previous weeks.

As expected, major market indices have shown an upward bias this week. The Dow set another all-time high while crossing the 12,500 mark. For the year, the Dow is going to post the best return among major indices–something that doesn’t occur often during bull market years.

The chart above shows the Dow as a black line compared to the S&P 500 (blue line) and the Nasdaq (gold line). You can clearly see that the while the other two indices have continued to advance, the Nasdaq peaked in November and has since been losing momentum. Normally money flows away from the Nasdaq toward the blue chip indices when investors become concerned about the strength of the economy. While the economy appears strong now, investors and traders have plenty of things to be concerned about.

These worrisome factors include housing: will prices continue to fall? The war in Iraq: is there a resolution in sight? And even politics: Bush is virtually a lame duck for the next two years. Are we doomed to two years of political paralysis while we wait to see who will win the White House in 2008?

None of these questions will be answered in the next week or two, but for each of the past three years, the first two weeks of January have given investors a thrill ride. That’s the main thing we need to be careful of at the start of 2007. Will stocks resume their upward path, or will we see a sharp correction like January of 2004 and 2005?

Keep a close watch on your accounts and be ready to make a quick exit if necessary.

Have a great New Year’s holiday.

F.S.

Merry Christmas. I hope all of you enjoy a wonderful holiday.

There isn’t much new information to write about today. The market is kind of in a holding pattern that is fairly typical for this time of year. If I had to make a prediction, I’d say stocks will have an upward bias in the shortened holiday trading week after Christmas, but after the New Year, all bets are off. There really is no fundamental or technical reason for a major correction, but in two of the past three years stocks have plunged in January. So I would urge investors to be cautious and be ready for a quick exit if stocks turn down sharply in the next few weeks.

There is one other topic I should cover briefly. If you are holding mutual fund positions, in the past few days or couple of weeks you might have been surprised by a sharp drop in the price or NAV of some of those funds. It could have been a pretty dramatic drop of even 10% or more in a single day. But while the price of the fund showed a dramatic drop, the account value did not decline. That is because of a phantom distribution that takes place with most mutual funds during December.

The distribution results from dividends paid to the fund by the stocks that it owns during the year. For accounting purposes, this distribution of dividends shows up as investment income paid to you. (And that is how the IRS views it if your mutual funds are not held in a qualified account like an IRA.) In reality, the distribution is calculated into the NAV of the fund and you simply end up owning more shares at a lower price. The account value never changes.

Let’s say you own 10 shares of XYZ Fund and on December 18, those shares were valued at $10 each. During the year, the fund accumulated dividends, yields and distributions equal to 10% of the fund’s total value. In reality, this stock income has been included in the price of the fund all year long. But on December 19, the fund passes these earnings on to you as a phantom distribution. So while your account value on December 19 is the same total of $100 as it was on December 18, instead of owning 10 shares valued at $10 each you now own 11 shares valued at $9.09 each.

You can see an illustration on the chart below. This is Wells Fargo Mid-Cap Disciplined Fund (SMCDX). It is up more than 18% this year, but the chart makes it appear as though the fund suffered a significant price drop a few days ago. In reality that was a distribution and the charting company will eventually figure that out and fix the problem.

 
If you haven’t seen this occur with a fund you are holding, you still might before the end of the year. When it does, now you will know what is happening and not panic when it appears that fund performance takes a major one-day plunge.

Have a great holiday.

F.S.

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With just a handful of trading days left in 2006, major stock indices remain near multi-year highs and near their highs for this year. Strong earnings reports and good retail sales numbers provided support in recent sessions and could still help stocks to advance through these last few days. As Christmas approaches, however, investors and traders tend to get distracted. Trading volume slips no one seems to want to make any major moves. So don’t be surprised to see stocks drift sideways or slightly upward into the early days of 2007.

As we near the end of the year, it is interesting to note which sectors have showed the most strength. As usual, I’m going to use exchange traded funds (ETFs) for this example. There are currently about 350 ETFs available, and they cover virtually every industry and market sector. So by looking at the performance of ETFs, we get a pretty good indication of market behavior as a whole.

Of those 350 ETFs, more than 100 have come into existence during this calendar year. Of the ETFs that have been available for all of 2006, only five have negative returns. They include a biotech fund, a semiconductor fund, and three internet funds.

So far there are 175 ETFs that have posted double-digit gains, The strongest sectors–those with gains of more than 25%– have been international funds and real estate. Next in line are energy funds, small cap funds and precious metals, with returns in the 18% to 25% range.

Most of the traditional, U.S. market sectors slip into the lower tier of funds. For example, QQQQ, a widely used ETF that tracks the Nasdaq 100, has gained less than 9% for the year. Sectors that have long been the mainstay of the U.S. market like retail, health care, large cap stocks, etc., generally have returns in the 5% to 12% range.

This year will go on record as being a decent year for the stock market, but certainly not an exceptional year. And in spite of the solid returns from select sectors, most investors are only going to see modest 5% to 10% gains in their 401ks, IRAs, annuities, etc. Most retirement plans are invested in the more traditional blue chip sectors of the market that have lagged this year’s leaders.

The chart below illustrates the current situation. The black line is the daily price activity of the Nasdaq. Notice that this index has mostly gone sideways since peaking about a month ago. The gold line is the S&P 500. By comparison, it has continued to advance and is making new highs. The blue line is a 50-day moving average of the Nasdaq and the bottom portion of the chart is a moving average convergence divergence (MACD). Both of these indicators show that while the Nasdaq’s advance has slowed, upward momentum remains strong.

While the Nasdaq has been moving sideways, there are plenty of sectors still advancing strongly. Surprisingly, over the past month the past month the strongest sector has been home construction. IShares DJ US Home Construction (ITB) is up 14% over that period and the Homebuilders SPDR (XHB) has gained 11.78%.

Below is a listing of the top 50 ETFs over the past 30 days.

So far December has also been a good month for the energy sector. Those gains should continue with an announcement today that OPEC plans to seek another reduction in output at its next gathering in February.

It’s hard to believe that Christmas is just 10 day away. I still have lots of shopping and other preparations to finish. I hope you are enjoying this special season of the year.

F.S.

Editor’s Note: MarketOwl is a totally free publication. We hope you find the commentary interesting, insightful and valuable. If so, please encourage your friends and acquaintances to sign up.

After three years of very difficult market conditions, the current rally has many investors feeling better again. But as the New Year begins, investors need to keep a close watch for any changes in market behavior. Beginning in 2004 and continuing through most of 2006, the Federal Reserve raised interest rates in an effort to slow the economy and stave off inflation. We are now seeing signs that Fed efforts are having an impact.

The cooling housing market throughout much of the country has been well documented. Now there are other, confirming indications of an economic slowdown.

The Commerce Department recently reported a 4.7% decline in factory orders in October, the third drop in four months and the biggest decline in more than six years. In November, the Institute for Supply Management’s index of manufacturing activity dipped below 50, a number that indicates a decline in manufacturing activity.

Another Commerce Department report showed a sharp slowdown in worker productivity in the third quarter of 2006. At the same time, wages and benefits grew at an annual rate of 2.3%, much slower than previously reported.

These and other reports present an image of an economy that is cooling down and one where inflation poses no significant threat.

The new concern for investors needs to be whether the Federal Reserve will be successful in its objective to slow the economy without causing a recession. Historically, this is something the Fed has rarely achieved.

If a recession is coming, how soon will it arrive and when will the financial markets begin to react?

John Mauldin is a respected market analyst and economic guru. He is forecasting a recession in 2007. He wrote, “An inverted yield curve is the best indicator of a recession coming within at least four quarters. When we saw the yield curve invert in September of 2000, we had a recession about 7 months later. …If we had the same timing, that would suggest a recession beginning in the second quarter of 2007.”

The inverted yield curve he refers to is the difference between the yield rates on short-term and long-term bonds. The inversion occurs when the short-term bond yields are equal to or higher than long-term rates, a situation that exists right now.

Of course, pinpointing the exact beginning of a future recession is impossible. Perhaps the Federal Reserve will be successful in its quest to avoid a recession. But rest assured that if Wall Street believes a recession is on the horizon, the stock market will correct significantly before it arrives.

If Mauldin’s forecast is correct and a recession comes in the second quarter of 2007, then a market correction could occur sometime in the first quarter. For informational purposes only, you might recall that in 2004 and 2005 stocks dropped sharply in January following fourth-quarter rallies.

For now all of the major market indices are trending strongly upward. As long as that is the case, it makes sense to remain fully invested. But when fundamental and technical indicators show a reversal in market momentum, investors should be prepared to step aside.

Some of the technical indicators to watch for include:

• Rising new lows—When the number of news lows on the Nasdaq exceeds 70 for two consecutive sessions, or when the number on the NYSE tops 50 for two sessions, that is a fairly reliable indicator of market weakness.

• Falling relative strength— A change in market momentum is signaled when the relative strength index of major market indices drops below 50 and then trends below that mark. (See the middle portion of the chart below.)

• Moving averages—When the indices cross below a 50-day moving average (gold line on the preceding chart) that is a strong signal that market conditions are no longer favorable for a sustained advance.

• Moving average convergence divergence (MACD)— When the MACD drops below zero, market momentum has switched to negative. (See bottom portion of chart.)

So far there is no reason to panic. In spite of initial signs of weakness, it is quite possible that the markets could rise significantly from current levels over the next few weeks. But the inevitable correction will come and when that occurs, we want to take some defensive steps to protect our portfolio gains.

F.S.