THE MARKETS

Despite a 306 point rally on Wednesday the markets failed to follow through and ended the week on a down note. The rally appeared to be a “short-covering rally” in a continuing down trending market. A short-covering rally is marked by a reversal of a trend lower in prices. The rebound in prices usually sees a step-up in trading volume. The phenomenon is fueled by 3 factors: 1) bears covering short positions to book profits; 2) momentum players jumping on the backs of their bearish brethren, increasing the pressure on bears to salvage profits by buying back rising stocks; 3) some longer-term investors (bargain hunters) stepping to the plate.

The NASDAQ, led by weakness in the telecom and chip stocks continued its slide for the fourth week in a row after posting a 7% run up on Wednesday’s rally. For the week, the Dow Jones Industrial Average lost 67 points (-0.67%) and closed at 9,939. The NASDAQ lost 13 points (-0.81%) and ended the week at 1,600.

It is interesting to note the upbeat nature of the media when a sudden surge in equity prices occurs. While Wednesday’s gains were impressive, the rebound broke a string of seven consecutive losing sessions on the NASDAQ. Note, too, that even after Cisco’s giant surge Wednesday (the stock ended up nearly 25 percent at $16.27), the shares have come back only to about where they were a month ago. Put differently, Cisco’s shares are barely back to their pre-Sept. 11 levels — and a long way from their early 2000 highs in the low $80s. Given the disappointing market performance of recent months and continuing uncertainties, investors are clearly in a defensive mode. While many stocks offer sound long-term value at current levels, there are few takers. Aside from some good corporate news, a round of heavy selling on high trading volume may well be needed before a sustainable upward trend develops.

Lastly, mutual funds had cash outflows of $1.2 billion for the period ending 05/08/02 compared to inflows of $3.6 billion the previous week.

THE COMPASS PORTFOLIOS

Additional downgrades this week increased the levels of defensive securities in clients’ portfolios. The only market segments continuing to show institutional support include the small-caps, value and growth (although support is waning). Investors must remember that one day doesn’t make a trend, and the prudent allocations we currently prescribe reflect a continued bearish trend. The blockbuster days like Wednesday are certainly welcome, and could be the start of something productive. Our investment management process adheres to the belief that investors who manage risk are rewarded over time, both in terms of financial stability and peace of mind. With this philosophy in mind, we continue to manage investment risk, and await the arrival of a trend reversal.

THE ECONOMY

Prices on the wholesale level remained under wraps as the government’s producer price index fell 0.2% during April, following a 1.0% surge in March. Excluding the volatile food & energy components, prices actually inched up 0.1%. The total 12-month wholesale inflation rate is currently a deflationary minus 2.0%, while the core rate is running at 0.4%. This report is not surprising as raw material and crude goods prices have fallen precipitously over the past three years. Everything from coffee to computers has become less expensive, and this has weighed considerably on corporate profits. The lack of pricing power – the ability for businesses to raise prices – has plagued companies for over a year, and it seems like more of the same is in store for the immediate future. This prolonged inability will also hurt business investment and capital spending. Without profits, companies have nothing to invest.

Democrats looking for a campaign issue finally may have a smoking gun: a 6 percent unemployment rate. But is the economy really sputtering, perhaps headed for a double dip? Doubtful, but until the answer is clear, the Fed will stay accommodative and the political waters will percolate. Like most economists, former Fed Gov. Lyle Gramley has trimmed his GDP forecast for this quarter and the rest of the year, but decent growth still is a good prospect, he says. Gramley doesn’t think this week’s jobs report was particularly weak, and he strongly rejects speculation about a double dip – yet he concedes that this recovery will be modest by historical standards.

A typical recovery since World War II has averaged 6 percent GDP growth in the first four quarters, which looks highly unlikely in this bounce. Gramley has seen a lot of business cycles, and he offers this tidbit: in virtually all recoveries, GDP growth has exceeded initial expectations. But this recovery could be different, with old standbys like housing providing little extra punch. Like most economists, Gramley has revised downward his GDP projections; he now expects growth of about 2-1/2 percent this quarter, and about 3-1/4 percent in the second half. He recently has shaved about one quarter percentage point off of both figures.