Another Rate Cut

Market Commentary: The Fed cut interest rates by 25bps today. The amount of the reduction was widely expected, and therefore it is easy to conclude that the market got what it wanted. The Fed is lowering rates in an attempt to head off a recession caused by the weak housing market and credit crunch. At the same time, Bernanke and crew are well aware that oil prices above $90 and rising material and grain prices are inflationary ingredients. For now, the FOMC has chosen to try to avoid recession.

We don’t expect equity markets to have an upside reaction of the magnitude they had after the last rate cut. However, some upside is expected if only for the fact that the uncertainty is now behind us. If the Fed action does its job in heading off a recession, then the upside will be justified and the path will be paved for further gains.

The 10-year Treasury yield has been slowly creeping upward the past week from an intra-day low of 4.31% last Wednesday to 4.42% prior to today’s Fed action. Sometimes it takes a few days for the market to fully digest the implications of an interest rate change. However, the immediate reaction suggests that the bond market may be focusing on the inflationary aspects of the cut. The 10-year Treasury yield jumped to 4.47%, and yield gains were evident in 5-year and 30-year securities also.

Sectors: Crude oil hit new highs again this week and closed today above $94 per barrel for the first time. Volatility appears to be part of the equation also as oil prices dropped nearly 4% in a pullback yesterday and then surged 5% today. Energy-related equities have not been keeping pace with crude oil prices, a divergence we would expect to be closed with a rise in Energy equities or a drop in crude. Energy company earnings have generally been quite robust, but executives have been attempting to dampen future expectations.

Styles: The market continues to favor Growth over Value. The dispersion between the two is not nearly as large as can be seen in our sector or global rankings, but it is definitely a factor in the current environment.

International: One day the story will change, but for now, it seems to be the same week after week, and month after month. China is providing the global growth leadership. Other Emerging Markets are close behind. The world’s three largest developed markets – USA, Japan, and the UK – are lagging. The US dollar remains weak versus other currencies and hit a new low against the Euro today, which provides an additional boost for the international holdings of US-based investors.

Heading Back Up

We noted last week that the stock market benchmarks appeared to have reached a short-term bottom. Friday brought a furious rally that continued today. The recent leadership by materials and energy may expand to include utilities as funds from that sector creep higher in our momentum rankings. Financials, real estate and consumer discretionary sector funds are still weak.

Earnings season is winding down and, contrary to early impressions, results aren't so bad. About two-thirds of the S&P 500 companies have beaten analyst estimates. Excluding a 25% drop in earnings at financial companies, profits grew at an average 11% pace in the third quarter. A heavy weighting in financials is holding back the broad-market benchmarks. There is still plenty of opportunity in the sectors that are showing growth potential.

The Federal Reserve meets this week to decide its next move on interest rate policy. The odds of a half-percentage point rate cut have dropped over the last few days, with the futures market now indicating a 98% chance the Fed will cut rates by a quarter-point instead. Bond market maven Bill Gross of Pimco Advisors thinks the Fed is on a course that will bring short-term rates down to the 3.5%. area. That seems hard to believe but we wouldn't bet against Mr. Gross.

Merrill Lynch Strikes Out

We noted in our last update that the market appeared to have found a short-term bottom. Despite significant intraday volatility, the S&P 500 has managed to close above support each day this week. Even more encouraging is that the benchmarks have held more or less steady in the face of several bearish events. Consider the following:

First, Wall Street icon Merrill Lynch (MER) revealed major mortgage-related trading losses in its 3Q report. $8.4 billion is a lot of money even to Merrill Lynch, and was a huge surprise since only two weeks ago the company had estimated its losses would be about $5 billion. The numbers themselves are less important than the fact that no one seems able to pin down exactly how big their losses are - or will be in the future. If it can happen to Merrill, it can happen to anyone. Today insurance giant American International Group (AIG) was hit with rumors of similar problems. The company issued a denial but AIG stock still plunged.

Second, crude oil prices moved up to a new record today, erasing several days of weakness. New tensions in the Middle East and a sharp drop in U.S. oil inventories drove prices higher, and the $100 mark is looking closer and closer. For now at least, supply concerns in the energy market are overwhelming the possibility that economic weakness will lead to a drop in consumption.

Third, the Federal Reserve meets next Wednesday and now seems nearly certain to cut interest rates in response to the market and economic turmoil. Whether it will have the desired effect won't be known for months, but lower rates will definitely lead to further dollar weakness. To the extent U.S. companies earn revenue overseas, this could be helpful in the short-term. The long-run impact is much harder to discern.

The net of all this is that the bifurcated market seems likely to continue. Financials, real estate and consumer discretionary stocks will stay weak while technology, energy and materials remain the upside leaders.

Tug-of-War

Market Commentary: It’s a classic market tug-of-war. Pulling on one end of the rope is a weak US economy caused by a steep correction in real estate, illiquidity in portions of the credit markets, and nervous consumers. Pulling on the other end of the rope are the booming international economies, especially emerging market nations, with insatiable demand for raw materials, finished goods, and everything in between. Like most tug-of-wars, there is much back and forth action. The concerns about the US are trying to pull the global equity markets down while the optimism surrounding the global growth story pulls the markets higher. The current earnings announcements drive this point home as company after company shows sluggish domestic results coupled with strong international results.

The domestic bond market is taking its cues from the domestic side of the equity tug-of-war. Concerns about a weakening US economy have driven the 10-year Treasury yield down to 4.33%, its lowest close since September 10, and its second lowest close in more than two years. Futures traders now place the probability of a rate cut next Wednesday at 100%.

Sectors: Our top three sectors, Technology, Materials, and Energy have their own mini-rotation going as they take turns providing the upside leadership. This week we have Technology on top as Energy backed off on apparent profit taking when crude oil briefly traded above $90 per barrel. The weak get weaker with Financials and Consumer Discretionary once again displaying negative trends.

Styles: Not much change in our style rankings this week, but the negative market action caused all categories to lose absolute strength. The market continues to favor Growth over Value.

International: China is distorting the results displayed on our charts below. The China market is so strong that it dwarfs otherwise very strong readings for Emerging Markets, Canada, and even the Technology sector. That is one of the advantages of including absolute strength information instead of simply producing a list in order of relative strength. It makes it obvious where the real strength (or weakness) resides and its magnitude.

Market Finds Support - For Now

Twenty years to the day after the Crash of 1987, stocks sold off Friday to the tune of 366 points on the Dow. This ominous-sounding number actually pales against the 508-point loss of October 19, 1987 if you look at each day in percentage terms. Friday's loss nevertheless added to October's reputation as a dangerous month for traders.

The good news is that the equity benchmarks stopped right about where we would expect them to. The area around 1500 points on the S&P 500, give or take a few points, provided solid resistance in August and early September. This level gave way on the rally of September 18 and the S&P 500 cruised upward and stopped just above its July high point. As is now apparent, the 1560-1575 zone is as high as the market seems prepared to go for now. Likewise, the 1500 area held as a bottom today. Further losses from here would begin to unravel the bullish case for stocks and point to an intermediate-term downtrend. The next few days will be critical.

Some of Friday's worst-hit sectors bounced today, notably financials, consumer discretionary and utilities. One sector that hasn't yet recovered is energy. Commodities of all kinds are weakening as signs of an economic slowdown continue to mount, and crude oil pulled back after briefly moving above $90. 3Q corporate earnings have not been a total disaster, but there haven't been many upside surprises, either. Consensus estimates now show an average profit decline of 0.6% for the quarter, which would be the first drop since 2002.

Short-term indicators suggest the market is oversold, and today's slight recovery is encouraging in that regard. If the selling has indeed run its course then next week's Fed meeting could easily spark a major rally.

Bearish on Banks

The anxiety about mortgage problems that hit the markets in August was based largely on rumor and fear of the unknown. With major banks now reporting their 3Q earnings, the previously unknown has become distressingly well-known. So far, the facts are not proving to be very helpful. Earlier this week Citicorp (C) reported a 57% plunge in earnings. Today Bank of America (BAC) surprised analysts by announcing a 32% drop in 3Q profits. Both stocks plunged.

Several major banks are working together on a plan to set up a special fund that will buy some of the illiquid debt securities that are distressing the financial markets. The as-yet-unnamed Entity is being greeted with considerable skepticism by traders, with many people interpreting the whole idea as a sign of panic by top banking executives. We suspect the idea will be dropped soon as the details of implementing it become more and more problematic. That will leave the bankers in a difficult position, which is why the financial services sector is again the weakest link in the stock market.

At the other end of the scale, emerging markets funds remained in a frenzy this week, thanks to a falling dollar and rising commodity prices - crude oil moved above $89 today. Energy, materials and technology are again providing leadership for the stock market, but negative momentum in the large-cap financial services and consumer discretionary sectors is holding back the index benchmarks. If you avoid those two sectors the stock market is actually in pretty good shape right now.

Energy to the Top as Oil Closes in on $90

Market Commentary: Equity markets took a breather this week amid traders’ anxiety surrounding the latest corporate earnings announcements. For the most part, earnings are coming in as expected – lower for financial companies with exposure to the subprime lending market and higher for companies feeding the global demand for raw materials. More than 70% of the announcements have contained positive surprises, but it is still early in the cycle with only 71 of the S&P 500 companies reporting so far.

Concerns are once again being raised that mortgage losses could accelerate and that the housing slump may have further to go, even with housing starts at a 14-year low. Additionally, the government’s core inflation figures do not reflect the impact of $87 oil and higher food prices. As a result, the 10-year Treasury yield dropped to 4.55% today from a level of 4.65% yesterday.

Sectors: Energy has reclaimed the top spot from Materials in our sector rankings as oil rose to nearly $88 this past week. Technology has been gaining ground and received another boost when Intel (INTC) announced better than expected earnings. Financials and Consumer Discretionary are now exhibiting renewed weakness, calling their recent rally attempts into question.

Styles: Although the market pulled back slightly this past week, Large Cap Growth held up the best, which is an indication that it is prepared to provide the fourth quarter leadership. We are starting to see a greater degree of dispersion among the various styles with 20 points now separating the top and bottom of our style rankings.

International: China continues to confound the naysayers by rocketing forward to new highs once again. China has been outperforming all other global markets by a significant amount for an extended period. There will come a time when it greatly underperforms global markets, but attempts to predict that slowdown have not been successful.

The Deluge Begins

Today the first Baby Boomer applied for Social Security benefits. Kathleen Casey-Kirschling, who was born at 12:00:01 AM on January 1, 1946, will become eligible for benefits when she turns 62 on New Year's Day. She is the first of many, signaling that the fiscal crisis experts have long predicted for the U.S. is no longer in the distant future. The Social Security system will begin taking in less in payroll taxes than it pays out to retirees in 2017. Social Security is only the first challenge; in 2011 the Baby Boomers will begin joining Medicare. Reasonable people can debate the impact this will have on the markets and the economy, of course. It will be interesting, at the very least.

As for the here and now, stocks fell today as Citigroup (C) reported a 57% drop in earnings for the third quarter thanks to delinquent mortgages and consumer lending shortfalls. Financial services and homebuilder stocks fell on the news, a trend that will likely continue if the other major money-center banks report similar results. The odds of another interest-rate cut by the Fed at its next meeting on October 31 are down to 32%, according to the futures market.

Crude oil rose to about $86 for the first time on concerns that the Turkish military may pursue Kurdish militants into one of Iraq's prime oil-producing areas. This provided a lift for energy stocks. In fact, energy was the only sector with any significant strength today. Wednesday brings the monthly Consumer Price Index data, and signs continue to point to more inflation.

Mid-Day Turnaround

This morning the stock market rose smartly, led by a huge rally in technology shares and strong gains in Asian markets overnight. Chatter about bubbles and crashes seemed to be giving way to a consensus that, irrational as it might be, the train was leaving the station and you had better get aboard. Bulls cheered as the S&P 500 and Dow both reached new highs. Then just after the lunch hour, attitudes changed. Tech stocks turned on a dime and headed down, ending the day lower.

Media reports blamed the sell-off on disappointing retail sales numbers, but that was already well-known hours before stocks began dropping. The catalyst for the tech sell-off appears to have been news that a Wall Street analyst had reduced his sales forecast for Baidu.com (BIDU), the so-called "Chinese Google." BIDU shares plunged and other tech stocks followed. The difference in the old forecast and the new one was only $2.2 million, but the symbolism was probably more important than the reality. Chinese stocks may not be immune from the law of gravity after all. BIDU is still up more than 200% this year, so shareholders can hardly complain.

In the last week, expectations for Federal Reserve policy have changed considerably, with the futures markets now indicating better-than-even odds that the Fed will keep rates unchanged at its next meeting on October 31. Given that stocks have climbed over the last week as well, the stock markets appears not be banking on lower interest rates. Investors seem to think that the Fed has achieved a nirvana state of perfect balance between economic growth and inflation.

The intermediate-term indicators are still solidly bullish for most domestic sector and style-based funds. Emerging markets like China are providing leadership for a global asset boom. We do not know when the real turnaround will come. For now, we think the best course is to hold on for the ride.

Any News is Good News

Market Commentary: Traders were hoping for another weak employment report last Friday with the hopes that it would entice the Fed to lower interest rates again. Instead, a much stronger than expected report was delivered. In addition, the weak August employment report was revised significantly upward. Based on prevailing expectations, we would have thought that stocks would decline. Instead, stocks rallied strongly on the news, and the strength has carried into this week as well. It seems the market is now in a “good news is good news” phase. It is earnings season once again, and expectations are running low. We will soon see if those lowered expectations are factored into current prices.

The 10-year Treasury yield jumped with the release of the employment report and is currently at 4.65%. The high-yield market continues to show improvement. Most major money market funds are yielding in excess of 5%, which is better than all points on the Treasury yield-curve.

Sectors: The Materials sector has been holding the top spot for a few weeks. Alcoa (AA) led off earnings season after the close yesterday and shares were down hard at the open today. However, coupled with the earnings miss was a statement from the company that it would increase its share buyback program. As a result, shares of Alcoa have stabilized somewhat. We expect this type of volatility to be the norm for this sector throughout earnings season. Chevron (CVX) issued a profit warning and was down nearly 2% at today’s open, taking much of the Energy sector with it. However, the Energy sector staged a strong turnaround on rising oil prices and finished the day as the top performing sector.

Styles: Various “Growth” styles now occupy the top three spots in our style rankings while those with “Value” in their name are near the bottom. There was an across-the-board improvement in momentum this week as nearly all equities benefited from the surprising strength of the September employment report.

International: We mentioned a week ago that China has probably reached the unsustainable parabolic phase of its advance. As if on cue, China underwent a sharp two-day pullback. However, it essentially recovered that decline and ended the week little changed from where it started. A cooling off period would be welcome by most long-term investors at this stage. Emerging Markets continue to exhibit superior relative strength versus the world’s three largest capitalized markets: USA, UK, and Japan.

New World Near

Today is Columbus Day, meaning that banks and bond trading were closed in the U.S. For that reason it is difficult to place much significance on today's action. Equity benchmarks drifted lower, led by materials and energy. We continue to see a pattern trend of recent laggards becoming leaders, and vice versa. This suggests that the market is near a turning point of some kind. Exactly what is turning, and where, is not entirely clear yet.

Friday was much more interesting than today. The monthly jobs report revised away the August weakness and showed a level of economic strength most analysts were not expecting. The conventional wisdom is that the Fed is less likely to reduce interest rates if the economy is strong. Sure enough, Fed funds futures quickly adjusted to show reduced odds of another cut at the next policy meeting on October 31. Yet the stock market, which is generally presumed to consider lower rates as a positive factor, rallied anyway. This allowed the S&P 500 to finally close at a new high, as other benchmarks had already done in recent weeks.

Holding Steady

The current stock market can be viewed as a glass half-empty or half-full. The good news is that the Dow Industrials and the Nasdaq 100 broke through major resistance in the last two weeks. The bad news is that broader benchmarks like the S&P 500 haven't kept up, and the leaders are now drifting sideways. The bullish way to spin this is to say that there is obviously not enough selling pressure to push the indices back down, so more upside is only a matter of time. How much time? No one knows for sure.

Tomorrow's unemployment report could break this deadlock, one way or the other. Wall Street economists estimate the report will show the U.S. jobless rate climbed to 4.7%, up from 4.6% the prior month. Traders appear to be hoping for a weak number, on the presumption that higher unemployment will provide further inducement for the Fed to cut interest rates. Anything higher than 4.7% could spark a rally, while a lower number could drive stocks lower.

Among sectors, energy and technology remain the leaders, along with gold and other commodity-related stocks. Utilities and financials are picking up some short-term momentum, but these trends need to develop further before we consider investing in them. Crude oil prices rose today after several days of weakness. A resumed downtrend in the dollar was helpful to energy stocks, and gold rose for the same reason.

Quarterly earnings season is here once again, so you can expect a barrage of corporate news in the next two weeks. The third quarter's results should reveal much more about the extent of damage from subprime mortgages and the housing downturn. As of now, traders seem to believe that the worst of the news is already known. If this is true then any surprises will likely be to the downside. Our indicators continue to grow more bullish for most markets and sectors.

China Gone Parabolic!

Market Commentary: Volume tapered off slightly this past week, although the overwhelming majority of that volume was to the upside. Earnings season is about to begin once again, and then we will see to what extent companies were affected by the third-quarter credit crunch. As always, the emphasis will be on the future, so the market will be paying close attention as to whether the worst is truly behind us or is yet to come.

The 10-year Treasury yield has been drifting lower the past two weeks but still has not returned to its pre-FOMC meeting level. The high-yield marketplace has made a nice recovery from the August lows, but the likelihood of making another strong advance in this economic cycle is quite small.

Sectors: The charts below consist of 32 green bars and just one red bar. The Consumer Discretionary sector is the only slice of our investment groupings that has not regained positive momentum in the wake of the recent credit crunch. The Financial sector is stabilizing with the help of the FOMC actions, and this is helping many industries. Real estate and the domestic consumer have not yet been helped by the interest rate cuts, but they have at least received a psychological boost.

Styles: A surge in Small Cap Growth stocks this past week caused some turmoil in our style rankings. Perhaps it has happened before, but we can’t remember ever seeing Small Cap Growth and Small Cap Value at opposite ends of the relative performance rankings. We will need to see if this one-week small cap growth leadership has any sustainability. Meanwhile, all style groupings exhibited improvement in their absolute strength this week.

International: With an intermediate-term momentum reading of 169, it is probably safe to say that China has reached the unsustainable parabolic phase of its advance. The inevitable pullback and correction could be painful when it happens, but it will probably be somewhat tolerable if viewed in the context of the overall move. China was not alone in its upside thrust this past week, as the rest of the world joined in. Even Japan, long the laggard of global markets, is showing renewed vigor.

Breakout Day?

As noted in our last update, U.S. stock benchmarks are flirting with new highs. If sustained, this development would open the door for another substantial uptrend. Today the Dow rose to match and slightly exceed its July peak. For all its fabled history the Dow is not a very useful proxy for the stock market in general, so we question the meaning of this accomplishment. We will be much more impressed when (and if) the S&P 500 does likewise, which did not happen today. Nonetheless, by many standards the stock market is regaining its momentum and the short-term trends are positive.

The recent bullish action is probably explained by the widespread impression that the "bad news" about mortgages, inflation, bonds and the dollar has all been revealed. If no more bad news is coming, then the benchmarks have nowhere to go but up, the thinking goes. That is why the worst-hit sectors of the third quarter, particularly financial services and homebuilders, were among the upside leaders today. This may prove to be the correct conclusion. So far, however, these sectors remain relatively weak except on a very short-term basis.

The futures markets continue to reveal a consensus that the Federal Reserve will be making further interest-rate cuts in the next few months. Bond expert Bill Gross of PIMCO said in his monthly commentary he expects short-term rates will fall to at least 3.75% in the next year. We would not bet against Mr. Gross. It seems clear that the Fed has decided to bail out the housing sector and Wall Street, regardless of the consequences to the dollar and inflation.