Large-Cap Breakout

On Wednesday the S&P 500 finally joined the Dow Jones Industrial Average in closing above its previous bull market peak, set in March 2000. Today brought little follow-through, and unless more gains follow soon this event may prove to have little meaning. It is psychologically important, though, in reminding investors how far the market benchmarks have come in the last seven years. It has been a wild ride, to say the least. Meanwhile the tech-heavy Nasdaq Composite Index is nowhere close to its last peak, so the gains are not as widespread as it might appear.

The S&P 500 breakout came late in the afternoon after the Federal Reserve released the minutes of its March meeting, revealing some unexpected optimism about the economy. More merger news and continued strength in overseas markets were also helpful to the bulls. Today brought a revised 1Q Gross Domestic Product report that was weaker than expected, showing growth at an annualized rate of 0.6%, the slowest growth rate in more than four years. On the other hand, new data on business activity and construction spending pointed toward more growth, so the picture is still cloudy.

The optimistic rhetoric about stocks may be a little overdone right now. Tomorrow's jobs report also has the potential to change a lot of minds. Nonetheless, if the Dow and S&P 500 can at least hold steady for a week or two, another step upward seems likely.

The utilities sector seems to have found support after a few days of weakness, and is already starting to move back up. Intermediate-term momentum remains positive, though on a relative basis the sector has fallen down the rankings. Energy continues to defy gravity, while basic materials and aerospace stocks marked important breakouts this week.

S&P 500 New High & Utility Sector Comments

Market Commentary: The S&P 500 finally recovered its bear market losses and closed at a new high today. Merger mania and private equity are still driving this market higher, and now China wants to get in on the action with a $3 billion private equity placement with Blackstone. Meanwhile, the 10-year Treasury yield hit 4.9% last Thursday, capping off a quick two-week run from 4.6%. We are likely to get some consolidation in the near term as the 4.9% level provided the upper boundary in January. Economic reports have been generally stronger than expected, so a bond market rally doesn’t seem too likely at this venture. The High-Yield segment is still the area to overweight in bond portfolios.

Sectors: The Utilities sector fell hard this week. Normally, Utilities is one of the best performing sectors during a market pullback, but that was clearly not the case this past week. Is something different this time? Given that much of the recent market weakness has been attributed to interest rates rising at a dramatic pace, and that Utilities are indeed an “interest sensitive” sector, then perhaps there really isn’t anything different. Higher bond yields are starting to allow bonds to be competitive with stocks, but with bond yields not likely to fall anytime soon, there does not appear to be any capital appreciation associated with a bond purchase. With a strong recovery taking place the past two and half days, the Utilities setback is looking like it is of a temporary nature. With yields in excess of 3%, which is twice the S&P average, investors can get their income and an opportunity for capital appreciation.

Styles: The upward march of US equity markets continues with Mid Cap and Large Cap stocks being favored over Small Caps. The Value versus Growth question does not have a clear answer as Value appears to be preferred in the Large Cap space while Growth is the current winner in the Mid Cap space. We would like to emphasize that these Value versus Growth differences are rather insignificant at the present time, and therefore do not warrant any portfolio action.

International: A touch of global cooling this week reduced the momentum for most of our global equity components. Latin America and Canada remain at the top and have separated themselves from the pack somewhat. Concern about the impending “bubble” caused China to retreat slightly this past week, which in turn reduced its standing in our momentum rankings.

Energy Corrects

The energy sector pulled back a bit last week and the decline continued today. This sector is prone to sharp, sudden breakdowns and hasn't had one in several months. The question is whether we are seeing temporary weakness or the beginning of another precipitous drop.

To the extent energy-related commodity prices drive the energy equity sector, the supply/demand picture is increasingly bearish. Crude oil dropped more than 3% today on signs that U.S. gasoline supplies will be adequate to meet summer demand. The recent spike in prices at the pump is largely a result of refinery downtime as equipment was reconfigured to produce the special smog-control blends many states and cities require in the summer. With most of that work now done, the supply pressure should ease somewhat. Positive events overseas, such as the end of an oil-worker strike in Nigeria and a historic meeting between U.S. and Iranian diplomats, also reduced the geopolitical risk premium built into energy prices.

The magnitude of energy's decline so far suggests that the sector is in the midst of a short-term correction. Given the propensity of energy stocks to fall hard and fast, however, we remain cautious. The same advice applies to the utilities sector, which has also pulled back but appears to have found a bottom. Record-setting volume in some utilities ETFs last week may prove to have been a selling climax, clearing the way for renewed upward momentum. Today brought a partial recovery, which was encouraging, but caution is still a good idea with utilities for now.

In the bigger picture, the S&P 500 is still trying to punch through long-term resistance and reach new highs. Continuing sideways consolidation is a positive sign, as it means there is not enough selling pressure to drive the index down significantly. Meanwhile small caps are picking up a little strength, which if it persists would be very helpful in driving the broad market benchmarks higher. We expect an interesting summer.

Greenspan Speaks

Former Fed Chairman Alan Greenspan seems to be getting bolder in his market prognostications lately. This may be related to his recent affiliation with the huge bond management firm PIMCO. As in the old E.F. Hutton commercial, when Greenspan speaks, people listen. They did so yesterday when he said a "dramatic contraction" seemed likely in the high-flying Chinese stock market.

Now Mr. Greenspan is a brilliant economist and a very smart man. As Fed chairman, he also had extraordinary power to influence the direction of the global economy. The current reality, however, is that Greenspan no longer has such power, and his record in short-term market forecasting is not exactly stellar. Remember this is the person who began talking about "irrational exuberance" in U.S. stocks in 1996, over three years ahead of the last bull market peak. So we are not convinced that his opinions about the Chinese markets are particularly noteworthy.

Nonetheless, at least two generations of traders learned that listening to Greenspan was an excellent way to make money, so the immediate response to his comments was to sell anything related to China. In today's economy, just about everything is related to China in some way. Add in the stubborn resistance U.S. benchmarks are encountering as they challenge new all-time highs, along with rising bond rates, and some short-term weakness should be no great surprise. The broader trends remain firm. A few more days like today will be necessary to begin changing the big picture. We are somewhat concerned about the decline in utilities this week and will be watching the sector closely.

Another notable news item today was an unexpected jump in new home sales. Some interpreted this as a sign of renewed strength in the economy, and this is one reason bonds fell in value. Look a little deeper and you will see that the price of the many homes that were sold last month fell significantly. In other words, real estate is on sale and buyers are doing what buyers do: snapping up bargains. What we still don't know is how far prices will need to drop in order to clear out unsold inventory.

A New Era?

Market Commentary: There has been a healthy amount of investor skepticism for the past year or more. This “negative” sentiment has helped provide an environment for the market to continue its upward path. However, we are now starting to hear “it’s different this time” stories as arguments against the inevitable market correction. Such stories always concern us. This bull market, we are told, is truly global in nature and therefore “large and long corrections are now a thing of the past”. We don’t buy this argument for a minute. First of all, the US broad market indexes are just now hitting new highs after being underwater for the past seven years. Large and long corrections can hardly be called a thing of the past when we are just completing one now. The Nasdaq provides an even more telling argument, as it still resides 50% below its former peak. Second, there have been many times in the past when the global markets acted in a synchronized fashion. Worldwide bull markets are nothing new; they are simply more obvious now. We are not saying the end of the bull market is imminent, but healthy skepticism appears to be giving way to “new era” bullishness. We all know what happens once the last bear becomes bullish.

Sectors: Energy, Telecom, Materials, and Utilities are still providing the leadership while Financials, Consumer Discretionary, and Consumer Staples all lag.

Styles: The rising tide of US equity markets lifted all style boats this week, and we have an across-the-board improvement. Mid-cap Growth was the strongest of the lot which helped it to capture the top spot in our momentum rankings.

International: Latin America surged this past week with both Brazil and Mexico gaining in excess of 4%. Canada also gained ground, putting a lock on its second place position in our global rankings. Japan is the weakest area on a relative basis, although it doesn’t appear to be in any danger on an absolute basis and has moved mostly sideways in 2007. The strength in our domestic markets this week has allowed the US to gain in our rankings after struggling near the bottom for quite some time.

Merger Menace?

More takeover activity drove the stock market to new highs today, with the S&P 500 briefly trading above its all-time closing high before dropping back in the afternoon. Bloomberg News reports a total of $1.04 trillion in takeovers so far this year, up 69% from the same point last year.

One might ask why this is so exciting. Obviously the profits can be handsome if you happen to own a stock that is bought out at a premium. Yet the real significance is in what this activity tells us about the rest of the stock market. While bears fret about stocks being "overvalued," the people who have the ability to buy entire companies clearly think that there are plenty of bargains at today's prices. Since these are generally pretty smart people, and they are willing to put their money on the line, it is hard to argue they are wrong. Therefore, stocks in general must have plenty of room to go higher.

The other angle is simple supply and demand. When private-equity firms buy a company, the overall supply of stock available to be bought goes down. To some extent it is replaced by new public offerings, but lately the value of IPOs has been lagging the value of takeovers. Hence we have a net drop in the supply of stock to buy, at the same time demand for stock is growing. This spells higher prices.

The people who are taking companies private typically plan to buy a company, fix it up, install new managers, then sell it again at a profit. This process can take several years to unfold. At some point, however, much of the stock supply that is now disappearing will again emerge into the public marketplace. When we enter that phase the market will probably be much closer to a major top than it is now. This doesn't mean more gains are guaranteed in the short term, of course. For the moment, however, the path of least resistance is up.

Market Update

Market Commentary: The mainstream media continues to focus on whether or not various indexes hit new intraday highs, while seemingly oblivious to the fact that new highs are an expected occurrence in a bull market. Every market pullback is being met with new buying, which has allowed the S&P 500 to maintain its steady upward advance. Meanwhile, the yield spread between High Yield and Government Bonds continues to narrow and is quickly approaching all time lows. High Yield Corporate Bonds are priced for perfection with yields currently less than 8% and default rates well under 2%. This suggests that the bullish run in High Yield that began in late 2002 is nearing its end.

Sectors: Energy, Materials, Utilities, and Telecom are still providing the leadership while Financials, Consumer Discretionary, and Consumer Staples all lag. Consumer sectors were hurt this past week as retail sales reports were not as robust as expected. Quarterly holding reports filed with the SEC today revealed that Warren Buffet and other large investors have increased their stakes in various railroad, health care, and financial services companies, which helped those groups have a nice pop today.

Styles: Small cap stocks are starting to separate from the pack. Unfortunately for them, they are separating to the downside. Micro-Caps continue to weaken and now sport an RSM value that is 24 points behind the current leader, Large Cap Value. Additionally, Micro-Caps have failed to regain their February peak and have lost all their intermediate-term momentum in the process.

International: China had a huge one-day surge that helped propel it to the upper tier of our rankings. Additional gains today should help it to hold onto that improved ranking next week. The Americas are showing extreme dichotomy with Latin America and Canada holding the top two spots while the USA lags behind all other markets except Japan. The US dollar has been exhibiting some short-term strength, which normally would provide some headwinds to international holdings. That has not been the case so far, as the momentum in international markets has been strong enough to overcome the negative currency translations.

Financials Fall

Tuesday morning we will learn how the Consumer Price Index fared in April. In a market obsessed with inflation statistics, the news has the potential to swing stocks and bonds in either direction. For this reason we would not read too much into today's mild downturn in the benchmarks. Major players won't make any big moves until tomorrow.

The leading sector on the downside for most of the day was financial services. An influential analyst downgraded the entire group due to concerns that rising bond yields will cut into earnings. Technology was not far behind, however. News that a private equity group will buy a controlling interest in Chrysler from DaimlerChrysler (DCX) was no great surprise but created speculation about the future of Ford (F) and General Motors (GM). The automakers, incidentally, were a prime reason the Dow managed a gain today while other benchmarks fell. The utilities, energy and health care sectors posted small gains. Materials and real estate were down.

On an intermediate-term basis, most sectors have lost some momentum over the last week but still remain firmly bullish in other respects. With major resistance just ahead for the S&P 500, some consolidation may actually be helpful at this point. Corporate news is still quite positive; profits at U.S. companies appear to have just marked their 19th consecutive quarter of double-digit percentage gains. Worries just a few weeks ago about housing and mortgages have faded away, at least for now.

Market lore says it is a good idea to "sell in May and go away." Probably some people will do so. We have a different view: seasonal tendencies are exactly that: tendencies. They are not guarantees. Long-term market strength does not appear to be in any danger for now. A disappointment in tomorrow's CPI report could certainly change the outlook.

Inflation Fighters

On Wednesday the Federal Reserve's Open Market Committee decided at one of its periodic policy meetings to do nothing. This was not a great surprise to anyone, and the stock market reacted with a giant yawn. Bond traders were a little more interested; Treasury prices fell when the Fed statement suggested the committee still regards inflation as the top threat to the economy. This means, for those not fluent in Fedspeak, that interest rates are more likely to go up than down.

At its last meeting on March 21st, the FOMC simultaneously confused everyone and set off a massive rally when it removed the "additional firming" from its statement. Chairman Ben Bernanke was forced to backtrack a few days later by vowing that the Fed really is serious about taming inflation. This week's meeting reinforces the view that the March statement was all a big misunderstanding. Rates are probably not going lower anytime soon.

We like to watch the 20-day moving average as a short-term market trend indicator. Prior to today, none of the large-cap indexes - Dow, S&P 500, and Nasdaq Composite - had closed below their 20-day averages since March 20th. Not coincidentally, this was the day before the Fed's ill-worded statement. Since then the benchmarks have moved steadily upward. Today's pullback threatens to end this short-term uptrend; the Nasdaq Composite closed slightly below its 20-day average and the S&P 500 is very close. Longer-term indicators remain solidly bullish, so at this point we see no need to change our positive outlook for stocks. Nonetheless, the road may get bumpy over the next week or two.

In sector action, utilities continue to lose relative strength while materials are picking up a second wind. The action in materials has a lot to do with a wave of merger activity and rumors of more to come. Falling oil prices have taken some of the froth from the energy sector and also gave a lift to the transports. Telecom and wireless are joining health care in the up-and-coming sector category.

Market Overview: Leading Sectors, Styles & Geographies

Market Commentary: The Federal Reserve's Open Market Committee met today and kept rates steady, as was widely expected. The FOMC statement said inflation was still the “predominant” risk for the economy, suggesting the bias remains toward higher rates. Market participants increasingly view these announcements as non-events. That may be a mistake - Bernanke must know that he has not yet gained Wall Street's confidence. He could easily decide to establish his credibility by doing something unexpected, jarring awake a market that has become complacent. Market benchmarks remain buoyant with the S&P 500 very close to an all time closing high.

Sectors: Energy, Utilities, Telecom, and Materials are leaders of the pack. Merger activity is driving materials stocks higher despite softness in commodity prices. Healthcare, especially pharmaceuticals and biotechnology, is picking up momentum and could move into the leadership soon.

Styles: The style category is marked by convergence. Large caps and mid caps are neck and neck, with the small cap category close behind. Micro cap is the worst performing area. The tenacious buyout binge that we are accustomed to hearing about these days is driving the larger type stocks to outperformance, as it seems that any and every stock is in play now.

International: Latin American markets are now outperforming the rest of the world. France’s election is over, and its market has zoomed to new highs. Other European Continental markets hitting recent highs are Belgium, Germany, Italy, Sweden, and Switzerland. The EU, Pacific ex-Japan, and even Canada – a beneficiary of the metals and mining melt up, round out the top of the list. Japan hovers near the bottom, with substantially lower momentum than the U.S., which is the next weakest market.

Tiny Bubbles

With the Dow breaking records as fast as it can set them, market pundits are starting to use the B-word. It's a bubble, you see. These stories usually feature words like "tulip" and historical references to the events of 1929, 1987, or 2000. Such comparisons may yet prove appropriate. We still suspect the bubble, if there is one, has ample room to grow much bigger before it pops.

At the risk of stating the obvious, the stock market consists of companies. These companies wish to make a profit. To the degree they do so, their share prices can be expected to rise. Last month we learned that the first quarter was, by and large, a very profitable one for most companies. This was a surprise to most analysts, and consequently share prices adjusted upward very quickly.

The next question is: can it continue? Can stock prices continue to rise? Yes, they can, as long as people are willing to buy. What makes people buy? Value. Investors buy stocks because they think stocks are going up. The current price is therefore considered unreasonably low. Over the weekend the King of Value Investing, Warren Buffett, spoke at the annual meeting of his holding company Berkshire Hathaway. Mr. Buffett said he would love to buy another company and is prepared to spend as much as $40-60 billion to do so. Berkshire Hathaway currently has about $46 billion in cash. This suggests Buffett thinks there is still value in stocks, even at today's bubble-like prices. The continuing stream of private-equity and merger activity supports this view.

Energy, pharmaceuticals, and utilities are still fighting for sector leadership. Utilities slipped more than the others and shows more signs of having topped out, but it could yet recover.

More Records

The economic news roller-coaster was on the upside today as government reports showed worker productivity climbed at a 1.7% annual rate last quarter. Meanwhile labor costs were up only 0.6%. That's good news for employers, who appear to be getting more work from their people without commensurate increases in pay. In the aggregate, this translates into higher corporate profits and is an indication that the surprisingly strong 1Q earnings were not mere coincidence. Stocks rose accordingly.

The Dow closed today with its third straight record. The S&P 500 crossed above 1500 for the first time since September 2000 and is less than 2% below an all-time closing high. Typically this sort of long-term resistance takes time to penetrate, but short-term momentum is so strong that we won't be surprised to see a quick breakthrough. Heavy trading volume and positive breadth are also bullish signs.

The technology sector appears to be taking its turn in the rapid rotation of sector leadership. Signs of economic growth suggest that companies will step up their buying of new hardware and software. The impending release of the iPhone from Apple (AAPL) may be behind much of the excitement in semiconductors. Reports from chipmakers who build components for the iPhone indicate that Apple intends to produce something in the neighborhood of 50 million iPhones this year. Will one out of six Americans really pay $500 for the latest gadget? Maybe not, but the manufacturers will make money either way.

Where's the Edge?

Market Commentary: We have closed the books on the month of April, and it turned out to be quite a good one with the S&P turning in its best monthly performance since 2003. Many domestic markets pushed to new highs multiple times during the month, and the Dow Jones Industrial Average surpassed the 13,000 milestone for the first time in history. However, not all segments are at new highs – the Nasdaq Composite Index finished the month of April at just 50% of its historic peak. Many analysts are concerned about the continuation of this bull market given that it is now one of the longest on record, that we are entering what many believe to be a weak seasonality period (May through October), and that earnings growth is expected to slow. The counter arguments tend to focus on the high level of take-over activity and the fact that the earnings-yield from stocks is higher than the yield from Treasury investments.

Sectors: Energy and Utilities share the top sector ranking this week, and Health Care has moved up another notch to #3. Last week we remarked about the signs of life in the semiconductor industry, and we had some additional follow through this week. This has helped push the Technology sector higher in our rankings, but Technology needs to make larger and more sustainable advances if it wants to overtake Utilities, Energy, and Materials – the sectors that have been driving the bull market of the past few years.

Styles: It looks like all styles are created equal this week as we have a virtual 8-way tie for the top spot in our style rankings. Eight of the eleven categories in our style rankings are crowded together within a tight 20-23 RSM range. The three that didn’t make the top tier include Small Cap Value (15), Small Cap Blend (11), and Micro-Caps (8).

International: The European Union has taken over the top spot in our global rankings for the first time in more than five years (possibly more, but the history of global trading vehicles for the categories we use is rather sparse beyond five years). Sweden, Netherlands, Germany, and Austria are big contributors to the strength of the European Union’s equity markets. China continues to lose momentum and has once again slid below the USA. Japan held up well in the late February / early March sell-off, but that short-term relative strength has not converted into anything longer term yet, and Japan is once again the weakest global market.