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It's good that bad things don't come in fours, because not many could have withstood a fourth straight down year for stocks. Enough was enough. The market brushed aside the war in Iraq and worldwide terrorism to rally from its worst losing streak since the Roosevelt administration. While not all sectors were lifted by the market's rising tide, those that gained ground were all over the map, including mining and metals, Internet commerce, tobacco, advertising, and leisure.

All major market indices have posted solid double-digit gains as we near yearend, with tech and small-caps leading the way by a wide margin. But are we out of the bear market? Can the rally continue in 2004?

The Bottom Line

Using fundamental, technical, and sentiment factors, the following bullets outline my expectations for 2004. Many of the themes from 2003 are carried through for 2004.

• Major indices will finish lower in 2004, although there will be some bullish follow-through early in the year. Short interest remains very high particularly in the various exchange-traded funds (ETFs), which have very high turnover and thus have a major influence on market direction. Uncovered short positions are always a potent source of buying power. And liquidity remains high due to unprecedented levels of government and consumer spending and borrowing.

• Following the early uptrend, I see mid-year and yearend levels for the major indices as follows:

  	Mid-Year	Year End
  Dow Jones	9,000	8,000
  S&P 500	975	850
  Nasdaq Composite	1,975	1,625
  Russell 2000	525	450

• Earnings growth for the S&P 500 in 2004 should only reach five percent, far below Wall Street's expectations of 10 to 15 percent.

• Going into 2004, we recommend the following portfolio allocation:
  
  U.S. Stocks - 30 percent
  International Stocks - 15 percent
  Gold Mining Stocks - 20 percent
  Cash - 35 percent
  U.S. Bonds - 0 percent

• Blue-chip indices are vulnerable as we move into 2004, especially in the second half. Earnings growth is suspect and valuations are at historically high levels. From a technical perspective, both the DJIA and SPX have rallied to levels at which major price resistance will continue to assert itself. Volatility has declined to levels consistent with major market tops and investor sentiment has become quite complacent and vulnerable to disappointment. Finally, geopolitical risk remains an ever-present negative wild card.

• I expect the Nasdaq will continue to outperform the Dow Industrials and the S&P, until the massive tech short positions begin to be covered. Despite its huge rally, tech remains an underinvested area relative to the blue chips, with only tepid enthusiasm from Wall Street analysts and with very modest flows into equity mutual funds (as I show below). The Nasdaq could rally as high as 2200 in 2004 before falling back.

• Emerging market stocks are more reasonably valued than U.S. stocks and are a decent hedge against continued dollar weakness.

• Gold mining stocks are a hedge against the very real possibility of rising inflation in 2004 and are also a hedge in the event of a major meltdown in the economy or an escalation on the war and terrorism fronts.

• Cash is favored over bonds because I see significant risk of capital depreciation for bondholders in 2004. Historically low yields should be pressured by rising inflation and a weak dollar. What's more, massive inflows into bond mutual funds during the 2000-2003 period (inflows to taxable bond funds reached a record-high $133 billion in 2002) should begin to be reversed.

• I expect inflationary pressures will heat up, forcing the Fed to ratchet interest rates higher. This will cause yields on the 10-year Treasury note (currently around 4.2 percent) to hit five percent by midyear and 5.5 percent by yearend.

Two Sectors I Like in 2004

While technology and gold may seem like strange bedfellows, the fact is that both had outstanding years in 2003 and should do so for the first half of the upcoming year as well. I say this not because there's any newly formed symbiotic relationship between the two, but because the sentiment backdrop for both is one of disbelief despite their impressive strength.

A rally (or decline for that matter) can be segmented into four stages. At the bottom is despair, which is replaced by disbelief in the early stages of the rally off a major bottom. This disbelief is gradually replaced by acceptance, as more and more funds move into the market. Finally, the euphoria stage is reached, at which point almost all the sideline money that could be earmarked for a stock or sector has been invested. That's where we see major tops. I don't see gold or technology having reached the acceptance stage yet, so I don't have a major concern about a top being reached for awhile.

As I said last year, I feel the opportunity continues to be in technology stocks, especially those falling into the mid- and small-cap categories. The primary drivers behind this outlook are listed below.

• Briefly, the Nasdaq Composite Index has fewer technical obstacles overhead and it's still in the very early stages of outperforming the S&P 500.

• Tech outperformance will be fueled in large part by massive short positions. Short interest on the Nasdaq-100 Trust (QQQ) stands at 315 million shares, just shy of the previous month's record high. In fact, QQQ short interest has more than doubled since April, and the short-interest ratio sits at a rally-stoking four days to cover.

• Wall Street analysts aren't exactly doing cartwheels over specific technology groups. Of the 27 sectors covered by Zacks Investment Research, only three technology sectors ranked in the top 10 in terms of the percentage of "buy" recommendations. That leaves plenty of room on the technology bandwagon for these doubters.

• Despite gaining nearly 50 percent so far this year, technology stocks are struggling to find any takers. On a year-to-date basis, there has been a net flow of assets out of technology mutual funds to the tune of about $250 million, according to U.S. Bancorp Piper Jaffray.

After being bearish up until the end of 2000, I turned bullish on gold in early 2001 and I'm continuing this posture heading into 2004.

• Gold will be seen as a hedge against inflationary pressure and risks to the economy both from within (e.g. , high deficits and debt loads, rising interest rates) and externally (war and terrorism).

• Gold has blown away the broader market for the past three years. Since bottoming in November 2000, the AMEX Gold BUGS Index (HUI) has appreciated more than six times. The recent pullback has been supported flawlessly by the 10-week moving average, a trendline the index has closed a week below only once since late April.
  
  

• Wall Street is apparently in the disbelief stage, as only 37 percent of covering analysts rank gold stocks a "buy," while 48 percent recommend a "hold" and 15 percent say "sell." What's more, the total market cap of the five top gold stocks is a little more than $50 billion. Contrast that with $85 billion for Dell or $295 billion for Microsoft.

• In the options market, the composite put/call open interest ratio for the gold stocks we track is higher (more pessimistic) than all but about one percent of the readings taken over the past year. Furthermore, composite short interest shot up 12 percent last month to reach an all-time high.

• Adjusted assets in the Fidelity Select Gold fund have increased by only about 40 percent over the past three years, while the HUI is up more than 500 percent. Incredibly, adjusted assets are down about five percent in 2003, even though the fund has gained more than 30 percent. Forget about euphoria, does this even sound like acceptance?

I wish you all a safe, healthy, and profitable 2004. Best of luck with your trading.