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WHAT THE MARKET WANTS: Sept. 2008

It was a tale of two markets again in August.Stocks moved higher in the beginning of the month in continuation of the rally off the mid-July bottom. Then suddenly, the market caught a case of the summer doldrums and spent the remainder of August in directionless and uninspired trading.

Market action was choppy, thanks to relatively anemic volume that sparked wild gyrations from day to day. Schizophrenic investors seemed to focus on the headline du jour, trying to get any hint of where the economy may be headed.

If you need a sign of the market's schizophrenia, try this: Just two months ago investors were begging for lower oil prices to stem inflationary pressures. Now they're concerned that falling oil prices means that the world economies are headed for weaker growth in the coming quarters. Either way, the market can't seem to win.

At the root of it all is the fact that we are still dealing with the fallout of the credit crisis and wondering how much more pain there is to endure. In the end, the only certainty seems to be that much uncertainty abounds.

One thing is crystal-clear. Small-caps continue their dominance of 2008. The small-cap Russell 2000 Index gained 3.5%, three times better than the 1.2% advance for the Russell 1000. Over the last six months (March 1 through August 31), the performance gap eclipses 1100 basis points (7.8% vs -3.3%) -- and the discrepancy is even greater when looking at the value segments (6.6% vs -6.1%).

All of the major indices we track posted solid gains in August, ranging from 0.8% for the Russell Midcap Growth Index to 4.6% for the Russell 2000 Value Index. But again, all of the gains were realized during the first several days of August, so it's a much different market as we head into the seasonally-difficult September and October months.

Value has outpaced growth over the last two months as investors have again begun to nibble on beaten down issues. Clearly, small-caps have been the place to be in '08. We don't see this trend abating any time soon as fears of a global economic slowdown will continue to impact large-caps more adversely than small-caps.

From a technical perspective, we'd like to see the Nasdaq close above its 200-day moving average for several days before we consider it a signal that the tide has turned. When that happens, the bulls will have seized control of the market for the first time this year. The Nasdaq has tried to clear this hurdle on three separate occasions in 2008 only to be turned back in a pattern of lower highs.

The proverbial line in the sand for the DJIA is shaping up to be the 11,700 - 11,800 level where the bulls and bears have waged battle for the past several months. You may recall this level marked the all-time high setback in 2000 before the bear market began, and more recently acted as key support in early 2008 before being pierced in late June. The Dow made four attempts to move past this area in August and failed each time.

As is common during times of uncertainty, the market favored stocks with steady and predictable earnings history and top-notch cash flow metrics.

Stocks have rallied off the July bottom, and it's now "make or break" time for the market during the typically volatile last four months of the year. If we can't hold at current levels, then things could get worse, quickly. However, a firm break above the resistance levels mentioned above would indicate that the market is pricing in a better-than-expected outlook six to nine months out.

Either way, we look for the current stalemate to be resolved soon and for volatility to return in September.


Next update:  Second week of October.