Energy Surge

Crude oil peaked above $70 today. Energy stocks initially led a broad market surge, but momentum slowed after the Federal Reserve kept interest rates steady, citing reduced inflation pressure. Technology stocks were also strong, especially semiconductor and networking issues.

The S&P 500 briefly regained its 50-day moving average today before falling back just before the close. It now appears that a wave of selling on Wednesday morning may have brought the recent downtrend to a climax. The index stopped falling just as it reached the June 8th low, so the current trading range is still intact. Another test of the top around 1540 could come in the next week or two.

The jump in crude oil came after a weekly inventory report yesterday showed tighter supplies and increased demand from refineries. Increasing unrest in the Middle East is also creating more concern than usual. Riots were reported this week throughout Iran when the government imposed gasoline rationing. Iran has plenty of crude oil, of course, but lacks refining capacity and has to import a large part of its gasoline and other fuels. If the U.S. succeeds in convincing other nations to impose further economic sanctions on Iran, domestic discord seems likely to increase. This doesn't necessarily mean open warfare will break out, but, as we have seen before, fear of the unknown is enough to drive prices higher. It's easy to imagine the Iranian government deciding to do something dramatic in order to divert public attention from economic woes.

If today's patterns continue, with energy and technology providing market leadership, our portfolios will be in good position to take advantage of the trends. Technology may actually have more upside at this point, having lagged behind while energy climbed this year, but these things are always difficult to predict.

10 Straight Weeks and Counting

Market Commentary: You may think your mind is playing tricks on you because it seems like the market is changing directions nearly every week. Don’t worry, there is nothing wrong with your mind. The market has changed direction every single week for the past 10 weeks (measured from Tuesday to Tuesday). The last time it put in back-to-back weekly performances in the same direction was in April, when it turned in two positive weeks in a row. If this pattern continues, then we should see an upward movement during the coming days. While 10 out of 10 may appear to be highly reliable, we wouldn’t base an investment strategy on something that is highly likely to be a coincidental random sequence.

The bond market has been on a short-term upward movement since the 10-year Treasury yield spiked to nearly +5.3% in mid-month. Opinions vary widely over whether the past two weeks have been the start of a new bullish trend or just a correction of the bearish trend. Meanwhile, the previously impervious high-yield market is showing signs of vulnerability and will require close monitoring in the days and weeks ahead. While no change is expected from Thursday’s FOMC meeting, Fed watchers will be standing by to parse the new statement when it is released.

Sectors: The choppy week to week action is taking its toll on our sector rankings with 50% of the major sectors now sporting intermediate-term downtrends. None of the negative trends are truly drastic, and the direction can easily flip during periods when the market is flattening out, yet the situation requires watching.

Styles: A market that reverses direction every week for 10 weeks is often a market that is having trouble exhibiting a strong trend. Our style rankings confirm this suspicion with all styles slipping toward a “trendless” environment that lacks momentum in any direction.

International: Global markets have experienced 10-week see-saw action similar to domestic equities, yet for the most part, they have been able to keep their upward trends alive. That is not to say the action has been smooth and without interruption, but they are still upward trends nonetheless. China has held up the best this past month and remains firmly atop our rankings.

Bearish Justice

This week brings a lot of potentially market-moving economic news as well as a regular Federal Reserve policy meeting. Treasury yields have fallen back from recent peaks, but the benchmark 10-Year Note remains above 5%. The rally in government bonds may have something to do with ongoing nervousness about mortgage-related securities and the downturn in home sales. Hedge funds and other large bond investors, fleeing from credit risk, are apparently buying Treasuries by the truckload.

Wall Street titan Bear Stearns (BSC) is being forced to commit billions to bail out two hedge funds that are filled with complex and illiquid interest-rate derivatives, following the refusal of other major firms to assist in propping up the funds. There is a bit of poetic justice in this. In the 1998 Long Term Capital Management crisis, Bear Stearns was the only major dealer that refused to join the hastily-arranged consortium that headed off a bigger meltdown. Now some of those same firms are letting Bear clean up its own mess. Even on Wall Street, what goes around comes around.

The stock market today traced a near-perfect parabola, reaching a mid-morning apogee before dropping into the close. On Friday, the S&P 500 closed below its 50-day moving average for the first time since early February and fell further today. If key support near the June 8th low of 1487 fails to hold, much bigger declines could be in store. Our best guess is that a rally will begin as soon as the Bear Stearns mess is resolved, but it is unclear how soon that will happen.

The energy sector was down as crude oil prices retreated slightly, but is holding about short-term support and maintains its strong intermediate-term momentum. Technology remains strong, while utilities, health care, financials and real estate are still in in downtrends.

Fear One Day, Greed The Next

The stock market seems unable to make up its mind which way to go recently, swinging between unreasonable fear to unrealistic euphoria from day to day and even hour to hour. To some degree this is simply normal volatility, which is surprising to investors only because they have been treated to historically unusual stability for the last few years. We think another factor is also at work: the major benchmarks, other than the Nasdaq, are at or near all-time highs and are naturally encountering resistance at this level. A few weeks or even months of consolidation in preparation for a breakthrough is typical in these situations. The fact that downturns have been contained suggests that long-term uptrends will ultimately prevail.

The energy sector corrected slightly on Wednesday but took off again today as crude oil again threatened to move above $70. We are entering a seasonally strong period for the energy sector, with increased summer demand and the potential for supply disruptions from hurricanes and political instability in oil-producing regions. Rebel attacks on energy facilities in Nigeria are only the latest difficulty. We fully expect the energy sector to remain very volatile, but the dominant trend is up.

We are also increasingly impressed with bullish action in the technology sector, and particularly semiconductors and telecommunications. Much of this is related the the impending introduction of the iPhone from Apple (AAPL). While expectations for the iPhone are almost impossibly high and disappointment seems likely once it is released, competitors are still racing to introduce new devices that promise to revolutionize mobile communications. This translates into high demand for the microchips that power these devices and the companies that operate wireless communication networks. As with energy, we anticipate significant volatility but will watch this sector closely.

Market Update

Market Commentary: Nearly all global financial markets rallied strongly this past week – bonds as well as stocks and international as well as domestic equities. The one-week (Tuesday to Tuesday) performance numbers look quite impressive as last Tuesday marked a short-term bottom. In that regard, the one-week numbers of a week ago looked rather dismal as the markets were ending that short-term slide. For the S&P 500, the two-week combination produced a nearly unchanged result of +0.2%. International markets were also nearly flat, easing off just -0.1% for the two-week period. Even with all the hoopla regarding the spike on 10-Year Treasury yields, the domestic bond market (Lehman Brothers Aggregate) had a modest two-week change of -0.2%. Nearly all global markets had a volatile two weeks, yet finished the period about where they started. Given this scenario, it is easy for us to identify the short-term leaders and laggards.

Sectors: The top sectors during the past two weeks were Energy at +2.3%, Industrials +1.2%, and Materials +1.0%. The two-week laggards were Consumer Staples -1.8%, Health Care -1.5%, and Utilities -0.9%. These two groupings also happen to coincide with our intermediate-term momentum rankings. This implies that intermediate-term relative strength has translated extremely well into short-term relative strength for sector activity.

Styles: The top styles of the past two weeks were Micro Caps +1.1% and Large Cap Value +0.5%. The laggards were Mid Cap Value -1.6% and Mid Cap Blend -1.4%. On the surface, these results appear to conflict with our momentum rankings. However, with those intermediate-term rankings currently in a narrow range, there is not much of a conclusion we can draw regarding the correlation between the short-term and intermediate-term results at this time.

International: The two-week results for global markets are highly correlated with our intermediate-term rankings. China, Latin America, and Diversified Emerging Markets were the top performers, all gaining in excess of +2.3%. Meanwhile, Japan was the laggard with a -0.7% return, and the UK joined the USA and EAFE (international markets) with two-week results that were near zero. Global equity strength clearly lies with the smaller capitalization markets.

Another Pullback and Another Buying Opp

Market Commentary: Another pullback for the equity markets this past week, but this time there was no place to hide. During the sell-off that began in late February, bonds provided a safe haven from the turbulence in the equity markets allowing balanced portfolios to do their job. However, bonds have not provided a safe haven in recent market action, and on a “risk-adjusted” basis, bonds have fared even worse than equities. The Lehman Aggregate Bond Index has shed about -2.5% the past five weeks and is now underwater for the year-to-date period. The decline accelerated this past week, and the yield on 10-year Treasury notes is now at 5.2%, after hitting a high of 5.3% in early trading today. One has to wonder, at what point do these yields become attractive enough to entice investors to sell equities and buy bonds.

Sectors: All sector categories lost value and lost momentum this past week. Although the declines were significant, the relative rankings saw little change. Not surprising, Consumer Staples, which is typically considered a “defensive” sector, underwent the least amount of damage. The Utilities sector was already under pressure, and the action of the past week pushed its intermediate trend into negative status. Energy still owns the top spot.

Styles: The strong upward trend that began in mid-March is weakening. Large Cap stocks found support near their 50-day moving averages this past week and are trying to lay the groundwork for another advance. Small cap stocks are looking much weaker than their larger brethren on a technical basis. Small Cap stocks underwent steeper than average pullbacks, and today’s rally only brings them back to their late February level.

International: International markets also succumbed to the recent downdraft, but China showed that it has the capability to chart its own course. China did decline over the past 5-day period, but it’s hardly noticeable on a chart. It maintained its upward momentum in the process and edged back into the #2 spot in our global rankings.

Bernanke, Utilities, Mid Caps, and Latin America:

Market Commentary: Equity markets established new highs again this past week before pulling back the past two days. Everyone likes to place the blame somewhere whenever the market declines, and this time many investors are pointing at Bernanke. The Fed Chairman stated that he remains concerned about a pickup in inflation but went on to say that he did not see a need to raise interest rates. Those words also put a damper on expectations for a rate cut anytime soon, causing both stocks and bonds to decline. The yield on the 10-year Treasury hit 4.995% today, just shy of 5%, a level not seen for ten months.

Sectors: The Utilities sector has now fallen to the bottom of our rankings. This quick fall is indeed non-characteristic action for this sector, which is typically marked by low relative volatility and slow changes in direction. Its recent action has been out-of-sync with the market and today undercut its low of last week. Energy still has a lock on the top spot with Telecommunications and Materials not too far behind.

Styles: Mid Cap Growth has held the top position in our style rankings for the past three weeks and for five of the past six weeks. Its advantage has been very slight but is now starting to widen. Mega Cap stocks continue to weaken on a relative basis and have joined Micro Caps at the bottom of our rankings.

International: A strong upside move in global equity markets provided a momentum boost to all of our global categories. Latin America remains the strongest area and gained +4.6% for the week with significant contributions from both Mexico and Brazil. Even Japan, the global laggard, had an above average week and brought its momentum back into positive territory.

Lucky Numbers

Just over three months ago a downturn in the Chinese stock market spread around the globe within hours, knocking U.S. stocks back on their heels. It took about seven weeks for the benchmarks to recover. So when the same Chinese market plunged almost 8% today, more than a few traders were nervous about a similar reaction. Their fears were apparently unfounded. The U.S. market opened with only minor losses which were easily recovered, and the day ended with small gains and another new record for both the Dow and the S&P 500. Even China-focused ETFs held mostly steady. PowerShares Golden Dragon China Portfolio (PGJ), for example, was almost back to break-even by the close of trading. Some closely related markets were actually up; iShares MSCI Singapore (EWS), which we hold in the ETF Portfolio, gained +0.9% today.

It seems hard to believe that just three months ago China was the linchpin of the global economy and it is now a mere footnote. Was the late-February meltdown an over-reaction, or was today an under-reaction? Clearly the Chinese market is overextended. Speculative fever is running wild among newly-affluent Chinese citizens. On the other hand, history shows that financial bubbles can get far bigger than most people think is possible. With China there is the additional complicating factor of government with near-total economic authority and a willingness to use it in pursuit of national policies. This makes the Chinese market exceedingly difficult to forecast.

Crude oil prices have climbed back above $66, and futures today reached their highest intraday point since April. This sparked additional gains in the energy sector but the risk of a reversal is still very high, in our view. The technology sector is starting to pick up momentum, especially the telecommunications and wireless groups. Utilities are holding steady and we are watching closely to see if the next move will be up or down. For today, we will keep all our model portfolios unchanged.