It has been a rather uneventful fortnight, as global bourses take a short breather after chalking up good gains. Just for the record, the Dow Jones Industrial Average (DJIA) briefly broke the 12,800-support and then tried to retest the 13,150 resistance, and failed.

The Straits Times Index (STI), too, was locked in a tight trading range with 3,150 being the lowest and 3,250 the highest. The trading pattern effectively suggests that 3,150 continue to be the support while 3,250 has become the latest resistance.

In the previous issue of Shares Investment, I said that “now that the STI is near 3,300 – even though there are strong signs of selling whenever we go near 3,300 – I expect 3,300 to be broken soon. Unfortunately, this is unlikely to happen without a short term correction that could take the STI to 3,185-3,150.”

My prediction for a short-term correction to 3,185-3,150 has come true, so what can we expect from now on?

Before we start reading into the “crystal ball”, we must ask ourselves a few questions – million dollar questions – that will dictate the direction of the stock market.

Have Economic Fundamentals Changed?
Let us not kid ourselves by thinking that economic fundamentals have changed because, in reality, nothing has really changed. Nevertheless, things have more or less found a firmer footing.

I have mentioned time and again that we are not totally out of the woods because we have yet to feel the effects of the interest rate cuts. Moreover, there have yet to be clear signs that the US economy has shown any forms of recovery.

For a start, consumer confidence – a measure of what the big American spenders feel about the economy – is languishing at levels that we have not seen for decades. If American consumers stop spending, then the US economy will be in deep trouble because domestic spending drives two-third of US gross domestic product.

Secondly, housing prices, which will determine if there are more writedowns in the future, continue to fall and the latest statement by Fannie Mae’s CEO definitely does not inject any confidence into the housing market.

CEO Daniel Mudd said that he expects housing prices to fall by another 25% and the crisis is now in the intermediate stage, or halfway through.

Adding fuel to the fire is rising oil prices, which threatens to feed into inflation. With the Nymex Light Sweet Crude trading at more than US$130 per barrel, inflation will surely start to grow amid a period where growth is at best anemic.

If all factors point to horrible times ahead, what is keeping the market on the uptrend?

The Feel-Good Factors
The markets started rallying in March after the US Federal Reserve began putting up rescue packages to save the big names in the financial circle from facing collapses. At the same time, the Fed also started cutting interest rates aggressively.

All these moves are expected to drag the US economy out of the doldrums.

While the rescue packages and the rate cuts have helped to instill some confidence back into the market, the economy has definitely not shown signs of improvements – even though the US did not slip into a recession in the first quarter.

The main reason for the market staying firm is expectations of a recovery – beliefs that the US subprime mortgage crisis will soon be over. Also, investors have been buying because the rate cuts are expected to help the US economy recover.

If we were to sum up the factors that have led to the rally, it is probably appropriate to say that the rally is more of an expectation rally than a recovery rally.

We all expect the US economy to recover and when it does, we will expect the rally to continue even further. If expectations of a recovery do not materialize, we can almost be sure that a capitulation will take place.

I have mentioned on many past issues that there are many other reasons that have been pushing up the stock markets, but I feel that expectations and a hugely positive trading sentiment are really the ones boosting the gains.

DJIA And STI
Now that the STI has corrected to the 3,185-3,150 range, as I had expected, we are ready for the local bourse to rally towards 3,250 followed by 3,300.

This could happen before the end of May, which could even stretch into June. Sell in May and go away?

To play it safe, the support at 3,150 must hold or else the STI may dip to 3,030 – a worst-case scenario.

The DJIA performed rather disappointingly, as it dipped below the 12,800 support on 21 May. It must now hold above 12,600 or face further dips to as low as 12,450.

Despite the “gloom” that I have painted just to be on the safe side, I believe that the STI and DJIA will soon go towards 3,300 and 13,200 respectively.

In the meantime, please give generously to quake victims in Sichuan and cyclone victims in Myanmar.