Last week was the fourth consecutive down week for equities and also the first time since 1982 that a New Year began with three down weeks in a row. For the week, the Dow Jones Industrial Average dropped 1.6% to close at 10,393, the S&P 500(R) Index lost 1.4% to 1,167 and the Nasdaq Composite fell 2.6% to 2,034. On the positive side, market breadth was reasonably balanced last week, with 1,600 stocks up and 1,800 down on the New York Stock Exchange. Additionally, some of the smaller cap averages, such as the Russell 2000 Index and the ValueLine Index, outperformed the S&P 500 Index last week, suggesting that the average stock is not performing as badly as the major indexes. In the bond market, interest rates moved lower at the longer end of the yield curve and moved up at the shorter end last week, a trend that has been occurring for quite some time. Over the past six months, in fact, the spread between the two-year Treasury and the 10-year Treasury has been cut in half from 200 to 100 basis points. This compression has occurred as a result of decent economic news and because of the Federal Reserve’s statements about inflation concerns.

With perfect hindsight, it seems clear that the equity rally in the fourth quarter of 2004 was a result of a large amount of good news: Oil prices had dropped from $55 to nearly $40 per barrel, the election results were decisive and resulted in optimism around the potential legislative agenda, the economy was generally viewed as strong enough, interest rates and inflation appeared benign, and even though earnings growth looked like it was going to slow, it appeared that it would remain at acceptable levels. Moreover, as the market moved up, success begat success and those investors who had been positioned defensively felt the need to reenter the stock market to try to participate in the rally. As a result, the environment became a little too bullish, and the air has been let out of the market over the last few weeks. From a fundamental perspective, oil prices have begun to creep back up, even though inventory levels also have been growing, and short-term interest rates have moved up as well.

We also believe that part of the concern is based on too much optimism that occurred around the legislative agenda during the end of last year. While President Bush has just begun his second term, he does so with only a 51% approval rating and has a very aggressive and controversial legislative agenda, including making tax cuts permanent, reforming Social Security, tort reform, reining in spending and prosecuting the ongoing war on terror. We believe he will encounter some difficulty in successfully turning this agenda into reality. Additionally, second-term presidencies historically have been difficult, as it is during second terms that presidents seem to encounter their most difficult political problems.

It seems clear that the sentiment in the market has changed significantly, and that over the past few weeks more investors have turned bearish. To us, all of these trends confirm our belief that 2005 will be a year of muddling through for the stock market. After the sell-off that occurred over the past few weeks, the market should be in a position to attempt some short-term rallies. Hopefully, these rallies will be successful, and we will be watching earnings, interest rates and oil prices to ascertain how long these rallies may last.

Mr. Doll is an analyst with Merrill Lynch.