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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.