Coal in the Stocking for Retailers

Retailers who were betting on strong holiday sales are not happy with the way 2007 is ending. Target (TGT) warned this week that same-store sales for December may actually decline from a year ago. Other reports show growth that is sluggish at best. There is some hope that shoppers who received gift cards will redeem them in the next few days, but if so it will likely be at steeply discounted sale prices.

Other signs of economic weakness continue to add up. Today's government reports on durable goods orders and employment were disappointing, and investors seem to be losing confidence in the Federal Reserve to engineer a "soft landing" and avoid recession. We should begin to see the real impact of the housing bust as 4Q corporate earnings are reported in the first half of January.

Meanwhile, crude oil prices were already jumping even before today's news of the assassination of former Pakistani prime minister Benazir Bhutto. Instability in the Middle East is obviously nothing new. What is new is the possibility that radicals could take advantage of Pakistan's political chaos to seize control of its nuclear weapons arsenal. Much will depend on how this situation develops. Even in the best case scenarios, the fear-factor will probably keep a floor under crude oil prices - and a cap on global economic growth.

Due to the New Year's Day holiday, our next update will be on Thursday, January 3rd. By then we will know how the markets opened in 2008. It will be interesting to watch. Happy New Year!

Ebbs & Flows

Market Commentary: Equity markets around the globe rallied strongly this past week. The end-of-the-year is now just three trading days away, and all major indexes have a good chance of finishing the year in the plus column. Such a finish was far from certain many times during the year. All major indexes were in negative territory in early March after sporting healthy returns the prior week. A correction in late July and early August caused these same indexes to give up their double-digit year-to-date gains and become dangerously close to slipping into negative territory again. One more correction started to take hold in October, resulting in a test of the August lows. For now, those lows have held, and the market seems determined to end the year on a positive note.

The equity market’s gains of the past week have been the bond market’s loss. The 10-year Treasury yield closed today at 4.28% after dipping below 4.0% for a brief period last week. Much of the equity market woes of 2007 are tied to losses in the subprime credit markets. However, government issued notes and bonds were a different story. For high-quality Treasury securities, the yields dropped and prices rose every time the equity markets weakened this year. This made Treasury securities one of the best diversifying asset classes of 2007.

Sectors: Energy, Materials, and Utilities were the leading sectors for most of calendar year 2007 and are now finishing the year in that position. It was by no means a smooth ride. Energy had five pullbacks of -6% or more, Materials had two double-digit corrections including a nearly -16% mid-year decline, and the often placid Utilities sector had a mid-year correction of nearly -12%. Of course, the real problem area was the Financial sector, which experienced its own bear market by dropping more than -24% at one point. The Consumer Discretionary sector narrowly missed having its own bear market by holding its decline to just under -19%.

Styles: Mid Cap Growth turned in the best performance for 2007 thanks to a strong showing in the first half of the year. The Large Cap Growth style took over the leadership reins starting in July and was one investment segment that managed to avoid having a double-digit correction during the year. On the other end of the style spectrum are the Micro-Caps, which lagged the market for most of the year and appear destined to finish in negative territory.

International: International markets also underwent a series of declines similar to the US, although the superior strength of the international markets generally meant that their pullbacks were also of greater magnitude. Latin America is finishing at the top of our rankings for 2007 even though it underwent four separate corrections of more than 10%, one of which turned into a -22% mid-year bear market. China spent more time atop our rankings than any other global region this year and will likely finish the year with the best returns. However, China’s stellar performance was punctuated with two separate bear market intervals where it posted declines of -21% and -25%. Japan will likely end the year with a loss and at the bottom of our rankings where it stayed for most of 2007.

Recession In Sight?

The Index of Leading Economic Indicators came out today at its lowest level in more than two years, suggesting that the economy remains weak and recession is not out of the question. The housing slump continues to hurt employment and consumer spending. Credit is still very tight. Recession may not be inevitable, but we are still getting a reminder of what it looks like.

What will a recession mean to the stock market? History tells us that the markets can be weak in a strong economy and strong in a weak economy. This is because the stock market does not reflect the present; it discounts the future. Investors buy now based on what they expect will happen later. These expectations can be wrong, of course. Nevertheless, it is often the case that stocks begin rising when people conclude that the end is in sight. Moreover, "the market" is not monolithic. Some companies can perform well even in a recession, while others will not. This means that as the economy bottoms out, certain sectors will rotate into favor while others will lose their momentum. What keeps things interesting is that the cycle repeats itself a little differently each time.

Currently the economy appears to be in the early stages of recession, but a substantial number of investors still think there may be a "soft landing." Opinions change daily as more data comes in, which is why we are seeing substantial short-term volatility. This may be amplified for the rest of the month by seasonally low trading volume. The first week of January will give us a much better sense of what 2008 holds in store.

Due to the Christmas holiday, we will have only one update next week, on Thursday December 27th.

Emerging Markets Slammed!

Market Commentary: The action in the equity markets has been predominately to the downside since the FOMC meeting of December 11. On an intra-day basis, the S&P 500 has pulled back more than 5%, the MSCI EAFE iShares (EFA) more than 7%, and the MSCI Emerging Markets iShares (EEM) more than 10%. Bright spots have been hard to find as negative sentiment appears to be taking the upper hand. Investor expectations are clearly lower, leaving some potential for upside surprises.

Credit markets are still a mess. The ECB injected an unprecedented $585 billion (more than half a trillion) of cash into the banking system to help bring this crisis to an end and ensure that banks have enough cash for year-end needs. Treasury yields are back in the same neighborhood they were prior to the Fed’s interest rate reductions last week. The 10-year Treasury yield closed today at 4.07% while traversing a range of 3.99% to 4.26% this past week.

Sectors: Utilities, Energy, and Consumer Staples held up the best this past week amid the global equity market pullback. The Materials sector did not escape the selling, getting bumped out of our top spot. The Financial and Consumer Discretionary sectors were knocked down hard once again with Financials dropping nearly 11% on an intra-day basis this past week.

Styles: The style rankings have been fairly consistent for the past few months. The domestic market continues to favor Large Caps over Small Caps and Growth over Value.

International: Strength in the US dollar and weakness in the international equity markets teamed up for a one-two punch for international holdings of US based investors. This has caused a high degree of movement within our relative rankings over the past week. We will need some additional time to determine if this is just a short-term event or the beginnings of a more significant shift.

Stagflation Lives

Those old enough to remember the 1970s may remember "stagflation." It describes an economy that features the worst of both worlds: low or negative growth and rising prices. Such times are decidedly unpleasant. In a depression, your income falls but the things you need to buy get cheaper at the same time. With inflation, everything costs more but your income is probably rising, too. Stagflation doesn't have a silver lining. It's bad no matter how you look at it.

Thus it was rather shocking to hear retired Fed Chairman Alan Greenspan tell ABC News over the weekend that he now sees the "early symptoms" of stagflation. Others concur; economists at JPMorgan Chase are forecasting the slowest global growth in four years this quarter, along with the highest inflation in a decade. The ongoing credit crunch is not easing despite the best efforts of the Fed and other central banks. Rapid growth in China and other emerging markets is driving up food and energy prices. It is beginning to look like the perfect storm may be coming.

Lipstick on a Pig

That is how one analysts describes the coordinated effort by the Federal Reserve and several other central banks to drive down interest rates by injecting new liquidity into the bond market. William O'Donnell at UBS Securities said "What the program will not do is cure the cancer that got us here in the first place - the housing bust, the collapse in credit conditions, etc. We view this new program as palliative, and not a cure. Much more time is needed and much more pain is up ahead."

The way this plan emerged is puzzling. On Tuesday the Fed disappointed the markets with a quarter-point interest rate cut and the Dow promptly plunged. More important, key lending rates did not budge, showing that banks were still unwilling to extend credit. Then Wednesday morning the broader plan was announced. It would have made much more sense and saved everyone a lot of grief had they announced both at the same time. It is unclear why this was not done. Confidence in the Fed is waning, and it couldn't come at a worse time. For this reason we continue to favor defensive equity sectors such as health care, utilities and consumer staples.

International funds had a nice run in recent weeks as the dollar lost ground against other major currencies. That trend appears to have slowed.

A Market Displeased

Market Commentary: At yesterday’s widely anticipated FOMC meeting, the Fed decided to lower the fed funds target rate to 4.25% and the discount rate to 4.75%, a reduction of 25 basis points for both. The typical market reaction to a Fed interest rate change is an immediate increase in volatility with a couple of directional reversals thrown in, all within the first hour of post-announcement trading. Yesterday was different. Volatility picked up, but all the action was to the downside. The market was apparently signaling its displeasure with the magnitude of the cut. Overnight, the Fed joined forces with the European Central Bank, Bank of England, Bank of Canada, and the Swiss National Bank to inject billions of dollars (and other currencies) into the banking system. The markets applauded this move by gapping up at today’s open and recapturing the better part of yesterday’s sell-off. The euphoria quickly faded with stocks drifting lower until the final hour when they briskly sold off and then turned around to rally into the close.

Treasury yields climbed most of this past week. The 10-year Treasury yield was hovering around 4.1% prior to the Fed announcement and then plunged to finish the day below 4.0%. Today, following a path similar to the stock market, the yield surged back up to 4.18% shortly after the open and then drifted lower to close at 4.08%.

Sectors: Energy climbed back into the #4 spot in our sector rankings this week, and crude oil moved back above $90. There is a noticeable disjuncture when viewing the absolute strength graphs of the major sectors. The chart depicts a typical smooth decline in strength as we move down the list from Materials to Industrials. At that point, there is a sharp break in graphical display before the poorly performing sectors of Consumer Discretionary, Financials, and Telecom show up. It almost looks as if there are a handful of sectors missing from the chart that should be inserted between Industrials and Consumer Discretionary, but that is not the case.

Styles: Once again we have very little change in the relative rankings among the various styles even though the absolute strength improved across the board. The domestic market is clearly favoring Large Caps over Small Caps and Growth over Value.

International: Latin America led the global charge this past week and moved into our top position. The Russian market also performed quite well, helping to improve the standing of Diversified Emerging Markets. Canada is at the bottom of our list again, with the US performing only slightly better.

Pushing On A String

We come once again to Federal Reserve time. The futures markets suggest a high probability that the Fed will cut short-term rates by 25 basis points to 4.00% on Tuesday. The bigger question is what sort of statement will accompany the announcement. The Wall Street honchos want reassurance that the Fed will take aggressive action to stabilize their bonus checks, oops, we mean stabilize the economy. We have no doubt the Fed will do what Wall Street wants. Whether they will succeed in stabilizing anything is another question.

The problem is this: whatever generous loan terms the Fed offers to the banks will not necessarily inspire those same banks to be any more flexible in granting credit to businesses and consumers. Economists call this phenomenon "pushing on a string." It is an evocative image; no matter how hard you push on string, all it does is pile up around your feet. Lenders are in no hurry to take on any additional risks after being stung so badly this year. Until that attitude changes, Fed policy will have little lasting impact. Perhaps Ben Bernanke has an unexpected rabbit in his hat, but so far we see no evidence of one. Tighter credit leads ineluctably to economic slowdown.

This outlook is consistent with the recent patterns in sector relative strength. The strongest intermediate-term momentum is found in defensive stocks like utilities, consumer staples and health care. Dollar weakness is allowing materials and energy to also move up, but those sectors face heavy overhead resistance. Our best guess is their momentum will fade shortly.

Just What We Need

Investors relaxed as media reports of a government bail-out plan for subprime mortgage holders seemed to be taking shape. The idea is to freeze interest rates for homeowners whose mortgages are scheduled to balloon to higher rates that would push them into default. We are wary that any such plan will ever see the light of day, and that it will have the desired effect even if it reaches fruition.

The first problem is that the troubled mortgages have been sliced and diced into a plethora of derivative securities owned by many different parties who may have wildly different goals. The legal and practical complexities of implementing a bail-out plan cannot be overstated. Think about all those papers you signed when buying your home, then multiply it by several million and you will get the idea. Second and perhaps more important, it is far from clear that freezing mortgage rates for some borrowers will solve their problems. It may just delay the inevitable. Lenders have been selectively doing this sort of thing for a long time, and reports show that the borrowers often end up defaulting anyway in another year or two. The best solution will almost certainly be to let nature run its course. As people default, more homes go up for sale and prices fall, the economy will naturally restore the balance that was lost over the last few years. The pain this will cause for many people is sad but there really are no better options.

The stock market is less concerned about borrowers and more concerned about the losses faced by banks and other lenders. Investors seem to welcome the bail-out talk since financial stocks are up sharply the last few days. Here again, we are concerned that the optimism is misplaced. Intermediate-term momentum still favors the economically defensive sectors like utilities, consumer staples and health care.

Follow-Through Day!

Market Commentary: The market kicked-off a new rally last week and established a strong follow-through today. For widely followed equity benchmarks such as the S&P 500 and the Dow Jones Industrial Average, it appears that the lows of last week constitute a successful retest of the August lows. It should be noted however, that it has been the Nasdaq and the international markets that have been providing the leadership for much of 2007, and the November pullback did not approach their August lows.

Investors are banking on another interest rate cut from the FOMC next week. Additionally, a word we haven’t heard in a couple of years – deflation – is now popping up in economic discussions. As a result, the 10-year Treasury yield finds itself back below 4% again, closing today at 3.91%.

Sectors: This past week produced an across-the-board improvement in our sector rankings, which now show half of the major sectors in positive intermediate-term trends. Relative strength is similar to last week and is exhibiting a definite bias toward defensive sectors such as Utilities, Consumer Staples, and Health Care.

Styles: The global equity rally that kicked off a week ago improved the absolute strength of all style categories while producing little change in the relative rankings. The domestic market is clearly favoring Large Caps over Small Caps and Growth over Value.

International: China has bounced back into our top spot in the global rankings, signaling once again that it may be premature to declare the bursting of the China bubble. US-based investors with large positions in Canada are learning that currency translations work in both directions. For the first 10+ months of this year, Canadian equity investments were boosted by a 31% appreciation of the Canadian Dollar (often called the Loonie) versus the US Dollar. However, in the past four weeks, the Loonie has plunged more than 9% against the greenback, pushing Canada to the bottom of our global rankings in the process.

Home Stretch

December is here and 2007 is turning out to be a year many investors would prefer to forget. It is, of course, still possible that a Santa Claus rally will help the record books record an "average" year. Stranger things have happened. Yet the evidence suggests that whatever December brings, the longer-term picture is less than positive.

The stock market is driven by many factors but in the end they all boil down to one: corporate profits. When companies are making money - or when investors at least antipate that the will make money in the near future - you can expect to see stable or rising equity prices. When business is not growing and profitable, stocks are less valuable. This is why some recent reports are more than a little disturbing. Despite record earnings from foreign sales, per-share profits for the S&P 500 companies fell almost 25% in the 3Q. Some analysts expect the 4Q to be even worse.

Of course, profitability is not evenly dispersed. There are substantial differences between the various industry sectors and even between companies of the same sector. The bulk of this year's losses are in the financial services sector thanks to the meltdown in subprime mortgage securities. Unfortunately this happens to be a very big sector, and its problems threaten to spread into technology, retail and construction spending. Softness in the economy is also part of the reason that energy prices are in retreat. So far, oil company profits are still strong, but if the economy moves into recession even this powerful sector could lose its long-term momentum.

The safe havens continue to be the defensive sectors: utilities, consumer staples, and health care, along with selected foreign markets and Treasury bonds.

Crunchy Credit

If humility is a virtue, then the leaders of Citigroup may be some of the more virtuous people in New York. This week they agreed to sell $7.5 billion in convertible stock to an investment fund controlled by the government of Abu Dhabi, one of the United Arab Emirates. The terms of the transaction are complex and it is not entirely clear who gets the best end of the deal. Nonetheless. it is hard to portray as anything other than a bailout. Citigroup is, in effect, borrowing money at an 11% interest rate and giving up a 4.9% equity stake. A Wall Street Journal editorial summed it up well, saying "it strikes us as unfortunate, if not a tragedy, that America's largest bank had to go hat in hand to Arab sheiks because of bad management and blundering U.S. monetary policy."

Having been reduced to nothing less than a subprime borrower itself, Citi and its peers are increasingly selective about lending money to anyone else. The resulting "credit crunch" threatens to push the economy into recession. The fact that year-end is approaching exacerbates this situation, as lenders are reluctant to acquire new loans that will have to appear on their December 31 balance sheets. This suggests the situation may ease in January; whether it will be enough to matter is impossible to say at this point. Consumers who face a softening job market, rising fuel and food costs, falling home prices and tighter interest rates can hardly be blamed if they decline to stimulate the economy with exorbitant holiday spending.

With all this going on, why did the stock market stage a major rally on Tuesday and Wednesday, then hold on to its gains today? The market is back in "Bad news equals good news" mode. Traders are betting that economic weakness will allow the Fed to keep dropping interest rates, and Fed officials are dropping plenty of hints to support this notion. Meanwhile, a pullback in oil prices suggested inflation pressure could ease. This week's equity gains can easily be characterized as nothing but an "oversold bounce," and unless there is more follow-through soon it will become difficult to argue otherwise.

Taking a step back, intermediate-term relative strength is largely unchanged despite all the fireworks. The defensive trio of utilities, consumer staples and health care is still the place to be for equity investors. Selected foreign markets remain in uptrends but show signs of weakening.

Vroom Vroom

Market Commentary: If you listen closely, that sound you hear is the collective sigh of relief emanating from Wall Street. Yesterday’s upward move was widely welcomed. Today’s upward move was a happy turn of events. However, that does not mean it is time to throw caution to the wind. After all, it has only been two days, and with most market benchmarks still below their 200-day moving averages, there remains much damage to repair.

The 10-year Treasury yield plunged this past week, hitting a low of 3.85% before moving back up to close at 4.02% today. The 3.85% level was its lowest in nearly two and half years and was a reflection of recession fears. Analysts are crediting today’s upside move in equities, as well as Treasury yields, to comments from Fed Governor Kohn that indicate further interest rate cuts are indeed a possibility.

Sectors: Our sector rankings do not take into account today’s upside action, which was led by the Financial sector’s impressive +5.8% gains. Unfortunately for Financials, that only recovers the action of the previous six market days. Today’s action will likely be referred to as a short-covering rally for the Financial sector, but there is also evidence that some opportunistic value managers were starting to buy. Today’s rally also lifted the defensive sectors of Consumer Staples and Utilities, indicating that a major sector rotation is not taking hold just yet.

Styles: Today’s rally also helped every style grouping. Mid Cap Growth was one of the laggards today, if you can call a +2.8% gain a laggard. Small Cap Blend received the largest bounce of the day with the Russell 2000 Index jumping +3.6%, while its tracking ETF gained +3.9%.

International: The global market correction took its toll on our global rankings this past week. Every category except the European Union has now flipped over to negative intermediate trend status, and the EU is dangerously close. Today’s US stock market rally boosted the prices of all international ETFs traded in the US. We will see how much of those gains are translated back into the international markets during the overnight trading sessions.

Freddie Mac Loses His Friends

With year-end rapidly approaching, the U.S. stock market is back roughly to the level at which it began 2007. Bearish news abounded this week. The quasi-governmental mortgage bank affectionately known as Freddie Mac reported heavy losses in its loan portfolio and may need a multi-billion dollar bailout soon. We won't be surprised if taxpayers are left holding the bag; Wall Street seems to have little interest in taking on even more risk at this point, especially after a new economic forecast from the Federal Reserve suggested more economic weakness is probably ahead. Corporate news shows no hints of recovery, either.

All the bad news is causing another wave of near-panic buying of Treasury securities. This has the effect of driving down the effective yield. The U.S. 10-year bond yield dropped below 4% for the first time since 2005. Two-year notes dipped below 3% as well. The yield curve is steepening in anticipation of further interest rate cuts by the Fed. Rising crude oil prices did little to help energy or any other sector. Today even the defensive equity sectors that had been market leaders retreated amid the flight to quality. This may have something to do with holiday trading schedules, but we won't know until next week.

Our indicators continue to suggest that stocks are at a critical juncture. A great deal of technical damage has been done in the last few days, and if it is not repaired soon then further losses seem likely. On the other hand, the market benchmarks are clearly approaching oversold conditions and due for at least a short-term bounce. We should know more next week when normal trading resumes. Happy Thanksgiving.

WHIPSAW

Market Commentary: The market continues to struggle with volatile day-to-day and intra-day swings being the norm. The major question surrounding all of this uncertainty remains unanswered – will the subprime slime drag the US economy into a recession, or will global growth save the day? Weighing in on the issue today, the Fed released its first set of forecasts under its new disclosure policy. Fed officials now anticipate a soft-landing, moderate economic growth, stable inflation, and low unemployment through 2010. However, they admitted that their forecasts are surrounded by uncertainty.

The 10-year Treasury yield continues its march toward a 3% handle by closing today at 4.05%, down from last Wednesday’s intra-day peak above 4.3%. This is its lowest yield in more than two years and suggests that bond investors currently fear recession more than inflation.

Sectors: Our sector rankings are displaying a typical “weak market” picture. The classic defensive sectors of Consumer Staples, Utilities, and Health Care are at the top of our rankings and remain in positive trends, while the other sectors are exhibiting negative intermediate-term trends. The Financials continue to be knocked down on bad news. Today, the Federal Home Loan Mortgage Corp (FRE), better known as Freddie Mac, announced a $2 billion loss. It closed today at a price that was nearly 25% lower than yesterday and about 60% lower for the year. Fannie Mae, the Federal National Mortgage Association (FNM), has experienced a similar fate.

Styles: Many of the style categories are now in full-fledged corrections, and some are approaching bear-market territory. Small Cap Value is showing a -15% decline from its mid-year peak, is at a 52-week low, and has wiped out all its gains of the past 20 months. Large Cap Growth and Mid Cap Growth have also experienced pullbacks the past few weeks, but so far, they remain well above their 52-week lows and are in much better “relative” shape than their Value counterparts.

International: Global equity markets continued their retreat this past week. On a relative strength basis, the theme of the past year remains the same – Emerging Markets continue to outperform the Developed Markets of the world.

Record Year on Wall Street

As the stock market continued to sell off, news reports today estimated that the top Wall Street firms will pay out record bonuses at year-end. The five leaders - Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch (MER), Lehman Brothers (LEH) and Bear Stearns (BSC), collectively employ 186,000 workers who are expected to split bonuses of about $38 billion. This is in addition to normal salary and benefits, and works out to an average of $201,500 per person.

Of course, many employees will receive far less than average because a small number of top producers will keep most of the money. The one group that seems destined to receive nothing is shareholders, who have lost some $74 billion in the market value of their shares this year. The companies will argue that competition for top traders is fierce and they must pay for talent. It remains unclear how many shareholders will agree with this logic.

Stocks tumbled today to open the holiday-shortened week. Financial stocks were again the downside leaders, with sector benchmarks dopping to test their early November low points. One analyst estimated that Citigroup (C) will have to write down another $15 billion in subprime loan losses. The classic defensive sectors are beginning to assert clearer market leadership in our momentum rankings. Utilities, consumer staples, and health care funds are the main islands of stability right now, while the uptrends in technology, energy and materials seem to have broken down. Gold funds still dominate the top of our lists but are falling fast.

Due to the Thanksgiving holiday, our next update will come to you on Wednesday, November 21.

More Things Change

Signs of change continue to grow in markets around the globe. The exact nature of the change is still unclear. Nervousness has returned to the credit markets, with no less than General Electric (GE) posting a 4% capital loss in an "enhanced cash" fund that was supposed to remain as stable as a rock. Other companies like Bank of America (BAC) have avoided similar fates for their money market funds only by injecting large amounts of company cash to reimburse the funds for losses in mortgage derivatives. As yet, no money market funds have "broken the buck" but it may be only a matter of time.

In any case, the recovery of the financial services sector now appears to have been nothing more than an oversold bounce. Another test of the lows seems likely. Crude oil prices are backing off, to the detriment of energy and energy service sector funds. Capital appears to be flowing toward the traditionally defensive corners of the stock market: utilities, consumer staples, and health care. Financial services, consumer discretionary, and real estate are the most bearish sectors for now, but technology is looking increasingly vulnerable. Further complicating the situation is dollar weakness. From a U.S. perspective, this means better results can be found in foreign stocks, even if those stocks are actually performing no better than their U.S. counterparts. Investment maven Jim Rogers made news today with bearish comments about the dollar and re-stated his intent to be out of dollar-denominated assets in the near future. We find it hard to disagree.

Waterfall

Market Commentary: A swift and volatile downside move was the primary action in the equity markets for the better part of the past week. The high-momentum segments of the market, those that have been exhibiting most of the recent strength, were hit the hardest. The Nasdaq 100, the domestic market leader, dropped -10.9% in just four market days. On the international front, iShares MSCI Emerging Markets (EEM) shed -10.2% and iShares FTSE/Xinhua 25 (FXI) plunged -14.5% in those same four days. Whether this marks an abrupt change in market leadership or just a temporary correction for the existing leadership remains to be seen. By the same token, the strength in the Financial Select Sector SPDR (XLF) this past week does not guarantee its woes are over.

The 10-year Treasury yield closed today at 4.27%, just slightly lower than a week ago. Meanwhile, yields continue to climb in the high-yield segment, suggesting that investors believe the odds of a recession are increasing.

Sectors: The big drop in high-momentum sectors this past week caused Technology and Energy to drop in our rankings. The defensive sectors of Utilities and Consumer Staples have now risen to the top while Telecom has replaced Financials at the bottom of our rankings. The Telecom sector is currently displaying extremely divergent results on a global basis. The US Telecom sector, as indicated in our chart, is extremely weak thanks to dismal performance from Verizon (VZ) and Sprint (S). However, the international telecom sector is behaving quite well thanks to strong showings by Vodaphone Group PLC (VOD), Vimpel Communications (VIP), and Telefonica SA (TEF).

Styles: The sell-off showed little mercy as all domestic style categories suffered this past week. There was not much change in the relative rankings, but absolute strength took a hit across the board, flipping the last five style categories to negative intermediate-trend readings.

International: More air was let out of the China market this past week, allowing us to drop the frothy label. Canada also took a big hit thanks to pullbacks in both the energy markets and the Canadian dollar. Latin America takes over the top spot in our global rankings for now, but with volatility remaining quite high, our rankings could dramatically change again. The bottom of the list has not undergone much change, with Japan and the USA continuing to occupy the bottom two slots.

Momentum Shift

"Everything people were buying they're now selling, and everything they were selling they're now buying." That is how one currency trader, quoted by the Wall Street Journal, described the turnaround in global markets. It's not quite a perfect description but is close enough. A lot can change in three days - and it did.

Prior to last Thursday, the technology sector was the place to be for U.S. equity investors, while financial services and consumer discretionary stocks were in solid downtrends. They're still in solid downtrends, but they've been joined by technology, industrials, and to a lesser degree health care, materials and energy. The remaining islands of stability are utilities and consumer staples. These are traditionally defensive sectors, the kind you would expect to be strongest in a period of economic weakness. It is no surprise, then, that they are rising in relative strength just as more signs of a recession for the U.S. economy become apparent. Meanwhile global strength seems to be shifting from Asia to Europe.

Bottoms Up

Trying to pick key market turning points is tricky business. Downtrends usually end with something traders call "capitulation." You could also call it "surrender." When the last bearish investor sells his shares and heads to the sidelines, then stocks have nowhere to go but up. Did the last bear sell today? We don't know yet. There was a fairly substantial turnaround in the afternoon after a very weak morning. This suggests that many of the "weak hands" may now be out of the picture. If so, we may look back on November 8th as a day of capitulation, much like August 16th and March 14th. Unfortunately we do not yet have the benefit of hindsight to be sure.

There is a key difference in the past week's action that we are watching closely. Technology has been the strongest sector for several months now with only a few short periods of underperformance. At the same time, financials have been the weakest sector. Tech stocks, the thinking goes, have little or no exposure to subprime mortgage derivatives. This explains the relative strength of both technology sector funds and Nasdaq-based style funds, which tend to have a heavy weighting in technology and only minimal exposure to financials. In the last few days technology and financials dropped together. Financials were still weaker, but the difference shrank considerably. What does this mean? Maybe nothing, but it is a significant change.

Today's technology sell-off was sparked by news from Cisco Systems (CSCO), which said that a decline in sales to automotive and financial companies is curbing growth. So maybe the tech sector is exposed to subprime mortgage losses - but indirectly as its customers in that sector are forced to cut spending. One day and one company does not make a general trend, of course. We will watch carefully for more signs of change.

FOMC in a Bind

Market Commentary: The market’s upside move after the Fed’s interest rate cut last week was short lived. In fact, most equity markets began a short-term downtrend the very next day. As part of their announcement last week, the FOMC did their best to dampen expectations for further cuts. Perhaps that is what the market chose to focus on, or perhaps it was additional subprime related write-offs and disappointing earnings reports. Volatility remains quite high with triple digit moves in the Dow Jones Industrial Average becoming commonplace. Today was a downside day, thanks to General Motors (GM) announcing a $39 billion loss and Morgan Stanley (MS) joining the subprime write-down parade.

The 10-year Treasury yield jumped a bit after last week’s interest rate cut, but like equities, yields on Treasury securities have been in a downtrend the past week. The opposite appears to be true for high-yield bonds as investor nervousness about the domestic economy is causing prices to fall and yields to rise for this group.

Sectors: Surprisingly, not all sectors lost momentum this past week. Technology bucked the trend, especially large-cap technology stocks, by posting solid gains for the week and building on recent momentum. The Energy sector posted very strong gains for the past week, but the overall momentum for this group remained about the same due to high volatility and a steep decline the prior week. The Financial sector, the epicenter of current market weakness, had another setback this past week. Financials continue to react negatively to bad news and should be avoided at least until bad news becomes expected.

Styles: The effect of a weak US dollar can be seen in our style rankings as well as our global rankings. A weak dollar helps large multinational corporations with large overseas operations and sales. These types of companies typically fall into the Large Cap Growth segment. Smaller firms that often import many of their goods and materials and have very little in the way of exports are typically hurt by a weak US dollar.

International: Some of the air was let out the China market this past week. It is something that has been expected for quite a while, as that kind of strength cannot be sustainable for too long. There is nothing to indicate that China is headed for a massive correction at this time, but we wouldn’t be surprised if it languishes for several months. Canada has jumped into the number two spot based on a combination of a strong currency and an economy heavily weighted toward energy and natural resources.

Bad News Deluge

Investors who have been waiting for the "other shoe" to drop may feel like a giant centipede is bearing down on them. A deluge of bearish news hit the stock market Friday and today. Subprime mortgage losses are still hitting Wall Street, with Merrill Lynch (MER) and Citigroup (C) both reporting larger-than-expected writedowns - and both CEOs leaving as a result. Investors clearly do not think this will solve the problem as both stocks continued to drop, taking financial services sector funds down with them. The analyst who first reported the possibility of greater losses at Citigroup reportedly received death threats. Homebuilders, materials, energy, and luxury retailers fell today. The only sector able to show significant strength was utilities.

Concurrent with all this, the previously impregnable Chinese stock market gave up the last month's gain as Premier Wen Jiabao said his government may delay a plan to allow mainland investors to buy stocks listed in Hong Kong. It remains to be seen whether this will be a quick correction or an end to the China boom. A violent government crackdown on civil unrest in Pakistan created more geopolitical concerns about the Middle East, combined with hopeful signs in the Turkey-Kurdistan disagreement to drive oil prices up and down in rapid succession.

Amidst all this it is actually quite impressive that some sectors are still in solid uptrends when examined on a long-term or intermediate-term basis. Technology in particular has substantial upward momentum. Energy and materials have weakened somewhat, though a rally in gold may help turn around the natural resource stocks. Major support levels on the index benchmarks are holding so far. The weakness of the last few days has brought the market back to the bottom of its trading range. That makes this week a critical test; stocks need to move back up quickly or there could be a lot more downside coming.

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.

Signs of Life

The U.S. economy grew at a 3.8% annual rate in the second quarter of 2007, the government reported today. This was a substantial increase from the 0.6% rate posted in the first quarter, causing some to feel a little more optimistic about avoiding recession. Unfortunately, the report does not reflect events from July 1 to the present, a period in which the housing market's downturn accelerated. Indeed, a separate report today showed that new home sales fell 8.3% in August, and the median sales price dropped by 7.5% from a year ago. This was the steepest plunge in housing prices since 1970.

Clearly, then, the housing sector has not yet hit bottom and may not do so for a long time. So why are stocks going up? The stock market appears to have accepted facts and is in the process of adjusting itself to a different environment. Financial services and consumer discretionary stocks are the losers in this scenario, along with the homebuilders themselves. Who wins? No one, really, except for the fact that the Fed's interest rate cuts have sparked inflation fears and a flight out of the dollar and into commodities and foreign markets. Hence we see major rallies in energy, gold, and emerging markets.

The stock market has been called a giant discounting mechanism. It values companies based not on their current condition, but on a consensus outlook for their future prospects. This year's reality matters less than next year's forecast. Whatever else is going on in the world, the market consensus appears to be that aggregate corporate profits will remain generally strong. There is a great deal of variation within the benchmarks because some companies and sectors are expected to do better than others. In the big picture, however, the prognosis looks a lot brighter than it did a few weeks ago. Hence we see the benchmarks moving back up toward their recent highs. Whether they will be able to break through is the next big test. The Nasdaq 100 is already above its July peak; the Dow and S&P 500 need to follow soon.

Holding Steady

Market Commentary: Volume is starting to pick up again now that the Fed has come to the rescue. August is typically one of the lowest volume months of the year. August 2007 was an exception, an extreme exception. Monthly volume for the NYSE and Nasdaq both hit new lifetime highs. Unfortunately, the vast majority of that volume came on the downside, leaving those huge volume spikes painted red on computer terminals across the country. During the last half of August, the seasonal reduction in volume did return. Volume typically picks up within a week after Labor Day, but that was not the case this time. It wasn’t until the FOMC meeting last week that volume started to return to the market. The markets haven’t staged a significant follow-through since the Fed-inspired action of last week. However, it is encouraging that the markets haven’t really given back anything either.

The Fed action has steepened the yield curve through changes at both ends of the maturity spectrum. Short-term rates and 2-year yields have dropped, five-year rates are essentially the same as they were before the meeting, but 10-year and 30-year yields have increased. If the Fed action was meant to help consumers, the opposite has happened. If it was meant to help banks that borrow short and lend long, then they should indeed reap some benefits.

Sectors: On a relative basis, very little has changed for sectors over the past few months. The strongest in late June are still the strongest today. The weakest in June are still the weakest today. On an absolute basis, all the sectors went through significant changes. All were strong in late June, most were weak in mid-August, and most have regained their strength here in late September.

Styles: There has been some minor jockeying for position in our style rankings, but the overall theme remains the same. The market is currently favoring Growth and Large Cap while shunning Value and Small Cap.

International: The performance of the Chinese market is putting the rest of the globe to shame. However, with an intermediate-term momentum reading of 138, China is certainly extended, and perhaps frothy.

Fed Rally Fading

Last week's Fed-inspired stock market bounce appears to be slowing down. It is possible that a brief pause will refresh the forces of bullishness and allow the benchmarks to break out to new highs. It is also possible that lower short-term interest rates will turn out not to be the economic panacea some expected. The Fed has administered medication with significant side effects that may or may not be tolerable. Long-term interest rates, for example, surged as it became clear that Ben Bernanke is not quite the inflation hawk he used to be. For example, stressed homeowners who thought they could refinance their adjustable-rate mortgage to a 30-year fixed-rate loan are finding that option is no longer as attractive, if it is available at all.

In the economic big picture, lower interest rates mean a bigger money supply. More dollars in circulation means that each dollar is worth a little less than it used to be, as compared to other currencies or to tangible goods. This phenomenon is called "inflation" and the markets seem to be anticipating more of it in the near future. Gold and crude oil shot up in the last week for that very reason. Gold is perhaps a better proxy for the monetary aspects of inflation, but energy may have more upside. Consumers around the globe who have little use for gold coins and jewelry have little choice about buying petroleum-based products. Rising prices the last few years have shown little impact on overall demand. With Treasury futures trading indicating that more rate cuts are likely, the downtrend in the dollar and concomitant uptrend in commodities seems likely to be with us for some time.

Shock & Awe?

Market Commentary: The most highly anticipated FOMC meeting in recent memory is now in the history books. Choosing to sacrifice the threat of inflation over market liquidity concerns, the Fed lowered both the Federal Funds Rate and Discount Rate by 50bps. This appeared to be what the market was looking for, and perhaps even more. Equity markets responded positively around the globe.

Although the Fed has lowered interest rates, the yield on the 10-year Treasury has climbed significantly the past eight trading days from 4.32% to more than 4.52%. The new level is slightly higher than the 4.49% level that prevailed prior to yesterday’s announcement. So far, the interest rate reduction has not filtered through to intermediate and long-term government securities, but don’t tell that to equity investors.

Sectors: All sectors received a boost this week with the most depressed (Financials and Consumer Discretionary) receiving some of the biggest bounces. The change in the environment has helped these groups, but the rate cut is an acknowledgment that these sectors are in trouble. Lower interest rates may also provide additional weakness for the US dollar and carries inflationary concerns. These factors help improve the outlook for the Materials sector, which has jumped back into the number two slot in our sector rankings.

Styles: The various investment styles are virtually unchanged from a relative ranking this week, but they all improved their absolute standing considerably. Mega Cap and Large Cap Growth remain the favorites while Micro Caps and Small Cap Value trail the field.

International: What’s good for the US is great for the world, or so it seems. Most of the globe got a good pop this week. The notable exception is Japan, which is mired in its own problems.

Waiting for Tuesday

Each Monday the Wall Street Journal provides a little day-by-day list of important events for the coming week: earnings announcements, economic data releases, etc. It is a nice feature that helps traders know what to expect. This week's version includes the usual minutiae, but might just as well have a single entry: "Tuesday, 2:15 Eastern Time, FOMC announcement."

FOMC stands for Federal Open Market Committee, the group which decides on the Federal Reserve's interest rate policy. Wall Street is certain this meeting will end with a rate cut and debates only whether it will be one-quarter of a percentage point or half a percentage point. Chairman Ben Bernanke and his colleagues are well aware that the market will not appreciate any surprises. Since they have not tried to signal any disagreement with the prevailing expectations, a rate cut of some degree seems very likely. More important will be the accompanying statement that may provide clues to future Fed policy.

Reaction to whatever the Fed does is difficult to predict. Indeed, with such widespread consensus it seems almost certain that the impact of a rate cut is already baked into asset values. It is hard to imagine anything the Fed could say or do that would create a bullish reaction for stocks - but Bernanke may have tricks up his sleeve we don't yet know about. The recent rise in commodity prices, especially oil and gold, and a concurrent decline in the dollar and yen are almost certainly related to the impending Fed action.

Across the Atlantic, a bank in the UK called Northern Rock is experiencing an old-fashioned bank run. The Bank of England bailed out Northern Rock last week, but customers are are still lining up (or "queuing" as the British like to say) to withdraw their deposits - to the tune of about $4 billion so far. This is minor in the grand scheme of things, but a troubling reminder of how some institutions may be close to the edge.

As a measure of how fixated the markets are on tomorrow's decision, consider that today's NYSE volume was the lowest for a full trading day so far this year. Clearly investors are in wait-and-see mode, and wisely so. Stay tuned for an interesting week.

Holding Pattern

A three day rally brought the U.S. stock market back near the top of its short-term trading range. An interesting chart pattern has developed in the S&P 500 over the last four weeks. Intraday high and low points show, since August 16, a series of lower highs and higher lows. In other words, stocks are trading within an increasingly narrow channel. One trendline or the other will have to break soon.

We suspect this quandary will be resolved through the catalyst of next Tuesday's Federal Open Market Committee meeting. Trading in the futures markets indicates a high probablity of a 50 basis point cut in the Federal Funds rate, from the current 5.25% to 4.75%. Anything less will be considered a disappointment. Fed Chairman Ben Barnanke and the other committee members haven't dropped very many hints, which suggests the market is probably guessing right. Pundits are now turning their attention to the impact a rate cut will have on the U.S. dollar. It won't be good, but the question is whether the effect is already reflected in exchange rates.

A weaker dollar is typically good news for commodity prices. This may be why crude oil rose to a new record high on Wednesday, briefly trading above $80. Energy-related equities, while picking up some momentum, still remain well below their July peaks. Gold has also popped higher, moving above $700 and sparking a rally in gold stocks. Fidelity Select Gold (FSAGX), for instance, jumped from # 25 in our momentum ratings this time last week to # 2 in today's table. We've seen it move just as quickly in the other direction, though, so we are not ready to buy gold funds just yet.

FOMC and Triple Witching Next Week!!

Market Commentary: The market recovery lost some steam this past week, but it hasn’t given up. Even though the rally stalled as the 50% retracement levels were reached, it would be premature to say that the rally has failed. The day-to-day action appears to be news driven and remains highly volatile. Equity traders are putting a large amount of emphasis on the upcoming FOMC meeting, and volume is expected to be light leading up to that event.

During times of commercial paper liquidity problems, the Fed has historically used the Discount Rate as the intervention mechanism. Greenspan bucked tradition by ignoring the Discount Rate during his 18 years at the helm. Bernanke has reinstated the use of the Discount Window in an attempt to separate the dual roles of the Fed: maintaining financial stability and controlling inflation. In the meantime, the bond market appeared to shrug this off, and futures traders are predicting a 74% chance of a 50bps cut to the Fed Funds rate next week. The September 18 FOMC meeting might be a meeting to remember. The Fed is receiving pressure to cut the Fed Funds rate in an effort to help the liquidity problems brought on by the subprime slime. Bernanke has made it known that he believes the Discount Rate is the appropriate mechanism for this particular concern. His resolve will be put to the test next week. He can hold his ground and leave rates unchanged, or he could attempt to appease the masses by cutting the Fed Funds rate. He could also do a little of both: cut the Fed Funds Rate but claim that heading off a recession is now a higher priority than keeping inflation under control, instead of saying that it is to address credit liquidity concerns. Meanwhile, the 10-year Treasury yield dropped as low as +4.30% on Monday (down from 5.3% in June) before moving back up to +4.41 today.

Sectors: We have a wide divergence in sector strength at the present time. There are two strong sectors, two weak sectors, and the rest are in the neutral range. Energy and Technology are the two strong sectors. Oil prices are again at new highs, and the Technology sector has successfully separated itself from the credit crunch. The weak sectors are Financials and Consumer Discretionary, a dubious honor they have held for quite a while. Real estate and the mortgage lending business are at the epicenter of the credit problems, and they are both part of the Financial Sector.

Styles: History does repeat itself, but sometimes the names are changed to protect the guilty. In 1999 it was widely believed that Large Cap Growth was all anyone needed. At that time, Large Cap Growth was the best performing style for the most recent 5-years and almost every other time-period you could imagine. Small Cap Value was at the other end of the spectrum. Last year we found those roles reversed. Investors were chanting the Small Cap Value mantra, as it was the new style king for 5-year performance (along with almost every other time-period you could imagine) while Large Cap Growth was at the other end of the spectrum. Styles rotate. Small Cap Value is now weak and getting weaker. It would not surprise us to see Small Cap Value at the bottom of the 5-year performance charts five years from now. We don’t know who will be on top, but the odds are in favor of Growth being part of its name.

International: Same song, different verse. China, and the rest of Asia excluding Japan, continue to provide global leadership. The “developed” markets of Japan, the USA, and the European Union are lagging.

Losing Jobs

Friday's weak jobs data, which we said in our last update could be pivotal, was unexpectedly weak. Economists had forecasted nonfarm payrolls would grow by 92,000 in August. The report revealed that the number of jobs actually fell by 4,000 instead. This was the first decline in jobs since August 2003. Moreover, job growth for July and June was revised downward.

Prior to Friday morning, the stock market was in its usual bad-news-is-good-news mode. If the economy is weak, the thinking goes, the Fed is more likely to cut interest rates, which is bullish for stocks. Something seems to have changed in market psychology in the last few days. Forecasts of a recession are no longer being greeted as welcome tools in the quest for lower interest rates. Bad news is now seen as simply bad news.

However you want to interpret it, the jobs data took wind from the sails of a stock market that had been trying to pick up momentum. In hindsight, it appears more likely to have reached the top of a trading range and is now exploring for a bottom. Today brought a small gain for the Dow and modest losses in broader benchmarks like the S&P 500 and Nasdaq Composite. Health care, utilities and consumer staples - the classic defensive sectors - were positive for the day while real estate, materials and industrials fell. On an intermediate-term basis, energy and technology remain the strongest sectors.

Dueling Data Points

The stock market seems to be back in data-dependency mode, results on any given day being based largely on whatever new economic and corporate data is hitting the newswires. Today was a good example. The day opened with much attention being paid to retail sales. The International Council of Shopping Centers, based on results from 47 retailers, said that August sales rose 2.9%, significantly ahead of projections. Wal-Mart (WMT), Target (TGT) and other chain stores also reported brisk back-to-school sales for the month. This suggests that consumer spending may remain strong despite the real estate downturn. On the other hand, the Mortgage Bankers Association said today that foreclosures and delinquencies are at record highs. Almost 15% of all subprime mortgages are late making payments. It's hard to see how that is good news for anyone.

Meanwhile, various Federal Reserve officials presented various opinions about the economy today, leaving observers no more enlightened than before. The consensus of today's speeches seems to be that the Fed may need a little more convincing in order to deliver a rate cut at its next meeting; none seemed to think that the housing slowdown has yet spilled into the broader economy. A flight-to-quality in the bond market remains in effect, with 10-year Treasury yields dropping fast and widening spreads with corporate bonds both in the U.S. and Europe.

Gold moved above $700 today for the first time since May, while crude oil traded above $77 before pulling back. With the Fed and other central banks acting to increase market liquidity, money-supply figures seem likely to increase. In that scenario commodity prices tend to rise. Other supply and demand factors are still relevant, of course, but all other things being equal monetary expansion is bullish for commodities. This is another factor arguing against an interest-rate cut.

Tomorrow brings the August unemployment and payroll data. This is always a critical report, and for seasonal reasons August tends to be weak. The consensus among economists is that nonfarm payrolls grew by just 92,000 in August. A lower number might be short-term bullish if it gives the Fed another reason to cut rates. With another seven market days to go before the Fed meets on September 18th, however, this number may be long forgotten before it matters.

50% Retracement

Market Commentary: Roughly half of the recent correction has now been recovered. This is called a 50% retracement and is considered typical action in financial markets. The recovery attempt stalled, or ran into resistance, late yesterday and today with many broad domestic market indexes trying to retake their 50-day moving averages. This is also considered typical action for financial markets. Volume has been lackluster during the two-week recovery, which tends to reinforce the stalling action. Volume is expected to start picking up soon as the seasonal slow period is now behind us. During the month of August, volume was a significant factor during the downswing and was noticeably light on the upswing. Now we will see what September brings.

The bond market is still mired in the process of sorting out the quality issue. There are still large pools of debt instruments labeled “unknown” with pricing that reflects that uncertainty. At the recent height of the liquidity crisis, it appeared that the only distinction being made was government or non-government. Now some level of order is being restored to some segments of the bond market. As a result, prices are drifting upward on lower quality bonds that can be separated from subprime slime. A Fed rate cut is being taken for granted later this month. This coupled with today’s release of the beige book pushed the 10-year Treasury yield down to +4.473% today, a new low for 2007.

Sectors: A 50% retracement is also common among sectors. However, we typically see a wider divergence of results here. Technology, Energy, Industrials, and Telecom are currently exhibiting a 50% or better retracement and are performing above average. The retracements for Financial, Consumer Discretionary, Health Care, and Utilities have fallen far short of the 50% mark, indicating significant weakness. These results are also reflected in our relative sector rankings.

Styles: The style segments have also had two weeks of recovery with non-uniform results. As indicated by our relative style ranking chart, Mega Caps and all forms of Growth have achieved a 50% retracement level, while the Micro Caps and Value have failed to do so.

International: The 50% retracement phenomenon is not limited to domestic markets. Most global markets have also traced a similar pattern the past two weeks. The most notable exceptions are Japan, which has fallen far short of the 50% level, and China, which raced to a new high more than a week ago.