Turnaround Monday?

The news wires were alive with encouraging commentary today. Headlines such as "Strategists Say Drop In U.S. Stocks Is Chance To Buy" and "Bulls Load Up On Stocks In Worst Rout Since 2002" and "U.S. Stocks Rebound On Upgrades" carried a none-too-subtle message: close your eyes and buy! Whether this was good advice remains to be seen. Nonetheless, enough people followed it to create a small bounce in the index benchmarks.

The S&P 500 came within six points of its 200-day moving average, the penetration of which would signal the end of a long-term uptrend that began almost a year ago. The Russell 2000 Small-Cap Index fell right through the same indicator last week and is struggling to find support. This is consistent with the flight-to-quality attitude that has prevailed lately; to the extent traders must be long in equities, they prefer to be in blue-chips rather than less-liquid small companies. A sustained recovery in the Russell 2000, when and if it happens, will be evidence that the bulls are back in charge.

Among sectors, the worst-hit from last week led the way higher today: basic materials, real estate, energy and financials all had above-market returns to start the new week. Energy services managed a small gain today and is very close to breaking out of the short-term downtrend that began last Tuesday. The automotive sector is still struggling but attracted some bids today. General Motors (GM) reports quarterly earnings tomorrow and is expected to show higher profits.

Finding The Bottom

On days like today we find ourselves recalling old spy movies in which the evil mastermind's hidden button makes the floor drop out from under the hero, plunging him to certain doom below. Against all odds, of course, the suave secret agent always finds a way out. Nevertheless, the sudden slide must be unnerving. So it is with the stock market when the bottom falls out: sometimes the only way to get back up is to go down first.

In saying this, we do not mean to downplay the magnitude of recent losses. We do suggest you keep them in perspective. It was only a week ago that the Dow Industrials closed at 14,000 for the first time. From then through today's close, the blue-chip benchmark is off -3.8%. So after a near-meltdown in junk bonds, multiple hedge fund blow-ups, earnings disappointments, emerging market chaos, and widening weakness in consumer spending - the Dow fell less than 4%. This doesn't strike us as reason to panic. If anything, it is a sign of considerable underlying strength.

Underlying strength or not, it is entirely possible the situation will get worse before it gets better. The penetration of the June low points is particularly troubling. Yet it is also possible that today's high-volume sell-off will prove climactic. If the weak hands are now flushed out, the way is clear for stocks to move higher. Time will tell.

A Flight to Quality

Market Commentary: Equity markets sold-off sharply this past week, not showing any enthusiasm for Bernanke’s two days of testimony or for the gloomy outlook put forth by bond manager Bill Gross. However, corporate earnings continue to surprise investors to the upside providing a solid slug of bullish action to offset many of the negatives. The weekly see-saw pattern we are following has extended its run to 14 straight weeks with a loss this past week, which sets the stage for a gain in the upcoming week.

The government bond market continues to gain strength with the 10-Year Treasury yield dropping as low as 4.90% in today’s trading. We can definitely now label this recent action as a “flight-to-quality” stemming from the continuing fallout of the subprime quagmire. The 10-Year Treasury yield hit a short-term high of 5.3% just six weeks ago, yet remains far above its intermediate-term low of 4.4% that was established in early December 2006. As predicted, the yield-spread between government and low-grade corporate issues continues to widen after reaching historic lows in early June.

Sectors: Merger activity moved into the off-shore oil drilling industry this past week allowing the Energy Service sector to post a gain and buck the negative market action. Oil prices remain well above $70 providing further support for the entire Energy sector. The generally weak market was most apparent in those sectors that were already exhibiting relative weakness, with the Financial sector dropping nearly 6% the past week. This sharp plunge has quickly brought the sector back to its March support level, so a short-term rally from here is certainly plausible. Energy, Technology, Materials, Industrials, and Telecom remain the favored sectors in this divergent market.

Styles: Investor skittishness is starting to show up in our style rankings with the Large-Cap blue-chip stocks moving toward the top of our rankings while the more speculative Small-Cap and Micro-Cap stocks migrate toward the bottom. The shift from Value to Growth is also growing more evident.

International: International markets also succumbed to selling this past week, with European markets appearing to take the biggest hit. Japan was able to brush off most of the selling pressure, as it has many times this year. Although Japan has lagged significantly during the recent global bull market, it has not exhibited any outright weakness and has acted as a cushion when other international regions underwent pullbacks and corrections.

Saved By Merger Monday

As of Friday afternoon, the U.S. stock market's recent upside breakout appeared to be reversing. As has so often been the case this year, Monday morning brought several merger and acquisition announcements that rejuvenated the bulls. Such news is usually positive for the broad market because it suggests that the "smart money" still believes stocks are relatively undervalued. While the gains faded in the afternoon, the S&P 500 did manage to move back above the key June high point around 1540.

One of the merger announcements this morning involved energy services, a sector in which all our model portfolios have a keen interest. Transocean (RIG) agreed to buy its rival GlobalSantaFe (GSF) for approximately $17 billion. The new company will be triple the size of the next largest competitor, which is bullish for the whole sector's profit margins. As of publication time most energy mutual funds had not reported for the day, but the Oil Service Index (OSX) was up +1.9%. PowerShares Dynamic Oil & Gas Services (PXJ) gained +1.2%.

The automotive sector lost much of its momentum last week, letting Fidelity Select Automotive (FSAVX) slide down the ranking table. Gold funds and transportation sector funds are starting to get more attention. We will watch these sectors closely.

Positive Earnings

If your television was tuned to CNBC today, you were treated to the sight of Fed Chairman Ben Bernanke speaking to the Senate Banking Committee. These events take several hours to unfold but are somehow always distilled into one or two sound bites that supposedly capture the essence of the day. Today's takeaway is that the Fed isn't convinced inflation is under control. In other words, don't expect an interest rate cut in the near future. Bernanke also talked about the housing correction, suggesting it could be bigger than initially expected and may cut into consumer spending.

Investors in a pair of hedge funds sponsored by Bear Stearns (BSC) received the unwelcome news this week that their money has gone up in smoke, demolished by leveraged bets on mortgage derivatives. BSC itself appears likely to survive the blow, but financial sector shares still lagged as people wonder if more such disasters will come to light.

Meanwhile, earnings season continued to unfold with generally good news. As of this morning, 112 of the S&P 500 companies had reported, and 62% beat the consensus analyst estimates. Only 21% of the companies have announced negative surprises. On average, year-over-year profits are up 6.3% for these companies, but there is substantial variation between sectors. Energy company earnings rose 67.4%, while consumer discretionary stocks saw a -19.8% drop. Google (GOOG) reported a 28% jump in profits after the close today, a little less than the Street was looking for. GOOG shares fell in after-hours trading.

The Dow and S&P 500 both posted new all-time closing highs today, with the Dow finally closing at 14,000 after several brief trips past that mark. The breakout from the June highs has remained intact except for a few hours of mid-day weakness on Wednesday. Large-cap stocks are clearly in the lead right now; small-caps are also near new highs but are having a harder time breaking out. We have no portfolio changes today.

13 Straight Weeks and Counting

Market Commentary: Equity markets rallied strongly this past week with an especially large move occurring last Thursday as the Dow posted a 283 point gain. Earnings season is in full swing, but it is too early to get a good read on the overall tone of the releases and the future outlook. Suffice it to say, the consensus expectation for lower year-over-year and quarter-to-quarter results will probably be correct, and companies will try to lower expectations for the second half of the year. The weekly see-saw pattern we are following has extended its run to 13 straight weeks by posting a gain these past five days.

The bond market is gaining strength, and the 10-Year Treasury yield dropped to 4.99% in today’s trading. Recent action might be considered a “flight-to-quality” in light of the continuing fallout from the subprime mess. However, the drop in the 10-Year Treasury yield only brings it back to its 50-day moving average, making it difficult to claim that Treasuries are truly benefiting from the subprime turmoil.

Sectors: Although portions of the Energy sector posted declines for the past one-week period, it wasn’t enough to prevent the sector’s momentum reading from increasing. We still have a major split between the “haves” and the “have-nots” on our sector rankings: Energy, Materials, Technology, Industrials, and Telecom are all in strong uptrends, while Financials, Utilities, Healthcare, Consumer Discretionary, and Consumer Staples are floundering. Bear Stearns told investors in its two failed hedge funds that there is little to no value left in those funds and that investors should expect little or none of their money back. This has been putting further pressure on the Financial sector.

Styles: While most market segments improved this past week, Micro-Cap stocks managed to lose some momentum. This had the added effect of creating a discontinuity in our style rankings. The drop-off in momentum as we move down the style rankings is relatively smooth with each successive category shedding just a point or two from the higher ranked style. That relationship holds true until we reach the last group, the Micro-Caps, where the difference is a full seven points.

International: Although the markets of China didn’t actually decline this past week, the gains were smaller than its recent trend, resulting in a small drop in the momentum reading back into the double-digit arena. Latin America had impressive gains, which helped propel the Diversified Emerging Markets category to new highs.

What's Not Working?

Crude oil futures reached $74.50 today, the highest point in almost a year. Continuing problems in the North Sea and Nigeria are keeping supply reliability in question while demand shows no signs of slowing. Energy-related equities consolidated after last week's sharp gains.

After inching to more record highs on Friday, the large cap benchmarks decoupled from each other today, with the Dow up and the S&P 500 falling slightly. More significant, perhaps, may have been the -0.5% drop in the Russell 2000 Small Cap Index. The small caps have been unable to break above resistance. While it's not absolutely necessary that they do so in order for the large cap uptrend to continue, bull markets are usually stronger when the small caps are moving higher.

The S&P 500 recent gains have been concentrated in energy, materials, and parts of the technology and industrial sectors. Meanwhile, vast parts of the stock market are moving sideways or even down. The worst place to be invested right now may be the financial sector. Banks, brokerages and insurance companies are all feeling the pinch of higher interest rates and the unwinding of the U.S. housing bubble. Merger activity may be the only thing keeping the financials afloat. Rising rates are also hurting the utilities sector, whose dividend payouts now face competition from Treasury bonds. Health care has popped up in the last few days but faces stiff resistance before it can move much higher. While retail sales numbers haven't been bad, both consumer staples and consumer discretionary stocks are having a hard time building any sustained momentum.

All this adds up to a market that is moving higher with fairly narrow leadership. That doesn't mean a crash is at hand by any means, but until some of the lagging sectors to pick up strength the upside momentum will be held back.

The Bulls Are Back In Town

A stock market that was waiting for a reason to move up got two of them today. First, the nation's largest retailer, Wal-Mart (WMT), reported stronger-than-expected 2Q earnings. Confirmed by strong numbers from several smaller peers, this suggested the real estate crash is not yet cutting into consumer spending power. Second, deal activity is still strong, with Anglo-Australian miner Rio Tinto offering $38.1 billion for Canada's Alcan Inc., surpassing a hostile bid by Alcoa (AA).

With these events driving consumer and materials stocks higher, the dam seemed to break and buyers piled into stocks of all kinds. The Dow Jones and Industrial Average and S&P 500 both closed at new record highs. Even the lagging financial and health care sectors picked up some momentum. Energy was strong despite a pause in the crude oil uptrend. Gold stocks popped up, with the Philadelphia Gold/Silver Index (XAU) rising 3.3%. The rally was global, with Asian, Latin American and European benchmarks also up strongly.

The quandary on days like this is that they usually end with many indicators flashing "overbought" signals. While the benchmarks broke above key resistance, it wasn't by much. Having done so, it is now very important that today's gains stay mostly intact. Today's heavy volume is an encouraging sign in this regard. A reversal from here would probably signal a quick trip down to the bottom of the recent trading range.

Two Camps

Market Commentary: Most equity markets retreated mildly this past week with the major domestic and international benchmarks pulling back 0.8% and 0.9% respectively. However, there were definitely some pockets of strength, most notably in Emerging Markets, Energy, and Materials. Earnings season is upon us again, and the consensus expectation is for lower year-over-year and quarter-to-quarter results. Reality versus expectations will unfold over the next few weeks and is likely to be a major force driving the market. The weekly see-saw pattern we are following has extended its run to 12 straight weeks with a decline during the four market days from Tuesday to Tuesday this past week.

The bond market seems to be picking up some volatility, but it’s not clear as to whether it is a longer-term trend or a short-term phenomena. We suspect it is (and will be) highly correlated to disclosure of sub-prime lending problems. Many investors are taking a fresh look at risk premiums, and we expect the spread between government and high yield securities to continue to widen as a result.

Sectors: The major market sectors are presently split into two camps – the strong and the weak. There is a clear dividing line between these binary states, making the distinction black & white instead of the gray readings we often encounter. Energy, Materials, Technology, Telecom, and Industrials are in the strong camp while Financials, Utilities, Healthcare, Consumer Staples, and Consumer Discretionary occupy the weak positions.

Styles: After nearly a seven-year non-interrupted relative strength run of Value over Growth, the evidence is mounting that a market favoring Growth is developing once again. Unlike the jolting shift from Growth to Value that took place in 2000, the recent shift from Value to Growth has been quite slow and orderly. Granted there have been a few false starts during the past year, and there is nothing to rule out another false start, but the odds are currently in favor of Growth for all capitalization segments.

International: Global markets remain quite strong, but everything pales in comparison to China. China is once again trending upward at an annualized rate of more than 100%. We typically consider this a frothy reading because it is a rate that cannot be sustained indefinitely. That does not imply that a correction is imminent, as momentum can decrease with a sideways movement or a simple slowdown in acceleration.

Earnings Time Again

With the second quarter of 2007 now in the books, corporate earnings season is on us once again. The semi-official forecast from Thomson Financial is for S&P 500 companies to collectively show year-over-year earnings growth of 3.9%. This would be a drop from the 1Q growth of 7.9%, which in turn was the first time in 14 quarters that growth was less than 10%. Much depends on how successful corporations have been in manipulating the analysts. The object of the game is to "beat expectations" and the best way to do that is to keep expectations low. We suspect the final number will come in above 3.9% and the market will be pleased. The next two weeks could bring fireworks, however, as some companies are bound to disappoint.

The International Energy Agency (IEA) released a report today supporting the case for higher oil prices. The report said "oil looks extremely tight in five years time," with "prospects of even tighter natural gas markets at the turn of the decade." Though the kidnapped daughter of a British oil worker in Nigeria was returned unharmed, the underlying issues we reported last week have not abated. The market responded bullishly to the news as crude oil closed above $72 a barrel today. Energy service stocks continued to climb, even as Fidelity Select Wireless (FWRLX) captured the #1 spot in our Fidelity Select rankings away from Fidelity Select Energy Service (FSESX). The entire technology sector continues to pick up steam, with semiconductors looking especially strong.

While small-cap and mid-cap benchmarks have similar momentum scores, the small-caps are having a hard time moving above resistance. Growth appears to be gaining a slight advantage over value. This suggests we may finally begin to see some dispersion in the style-based fund rankings after months of little difference. Time will tell.

Hilton in the Headlines

In a low-volume, holiday-shortened week it would probably be a mistake to draw too many conclusions from market activity. Looking at the benchmarks, it's easy to say that the bulls are back in charge. That may well be the case, but we will be a lot more confident when we see the June highs surpassed. It hasn't happened yet. Until it does the best we can say is that we are approaching the top of a trading range. Over the last month, this range marked lower lows and lower highs, a fact which should give bullish advisors reason to pause.

On a more glamorous note, Hilton was back on the front page today. This time, it wasn’t Paris who grabbed the headline. Private equity behemoth Blackstone Group (BX) announced the acquisition of the original Hilton hotel chain (HLT) for $20.1 billion – a premium of 32% over Tuesday's close. This action spurred investors to look for other hotel buyout targets and gave a boost to consumer discretionary and leisure-related sector funds.

Statistics released today revealed that service companies grew at a faster-than-expected rate in June, the best showing in fourteen months. The bullish sentiment in services could not overcome a jump in Treasury yields, however, and the day ended on a flat note.

Crude oil rose to a ten-month high on concern that unrest in Nigeria may affect oil shipments. A surprisingly high inventory report this morning cut into the gains, but by the day's end both crude oil and energy sector funds posted small gains. Momentum is so strong that it would not take much of a supply disruption to make energy spike higher.

See-Saw Up, See-Saw Down...

Market Commentary: The weekly see-saw pattern we commented on last week has extended itself once again. If you are keeping score, it has been 11 straight weeks. If the pattern continues, the four market days leading up to next Tuesday (July 10) should have a negative return.

The rally this past week was broad and certainly welcome, but many indexes failed to establish new highs in the process. The most notable exceptions were the Nasdaq 100 and Nasdaq Composite, both of which established new highs for this cycle, while remaining approximately 50% below their historic peaks.

The sub-prime lending woes have not sparked a “flight to quality” in the bond market as of yet, but it appears that maybe a “flight from junk” is underway. The yield on the 10-year Treasury is now at 5.14%, reversing sharply from below 5.0% earlier in the week. Additionally, the spread between high-yield and government bonds is now widening after reaching historical lows about a month ago. The pullback in the high-yield market has been orderly so far, but it is not clear that money leaving the high-yield segment is shifting to Treasuries.

Sectors: The relative strength of the major market sectors is readily apparent in the graphs below. Energy remains on top with Materials, Telecom, Industrials, and Technology in a near four-way tie for second place. The Financial sector has now replaced Utilities at the bottom of the list as sub-prime concerns continue to spread.

Styles: The style categories remain in a relatively tight range with Mid-Cap Growth still in the driver’s seat. The headline news stories about a month ago of a market shift to Mega Caps appears to have not come to fruition with that group currently occupying the bottom spot in our style rankings.

International: China, Latin America, and other Emerging Markets continue to provide the global market leadership with the large capitalization markets of the USA and Japan lagging. China is once again starting to appear frothy, but it has demonstrated that it is capable of having extreme upside momentum for an extended period of time.

Acquisitions and Energy

As we noted last week, the Federal Open Market Committee (FOMC) voted to keep the economy moving at a steady clip by not changing the funds rate from 5¼ percent. U.S. manufacturing unexpectedly rose to its highest level in 14 months because of gains in production and new orders. Treasury yields touched three-week lows despite continuing concern about the sub-prime mortgage market. A flight to quality after terrorist bombings in the U.K. probably contributed to the Treasury rally. The S&P 500 resumed its intermediate-term uptrend but may still need further consolidation.

The stock market this year has been driven by heavy merger and acquisition activity, and a recent slowdown in this trend may become problematic if it continues. The year's record pace of takeovers slowed by 37% in June, according to data compiled by Bloomberg News. Many observers point to the recent IPO of Blackstone Group (BX) as a sign of the top, and the poor performance of the shares so far certainly does not inspire confidence. If the perception that stocks are fully valued at current levels continues to grow, then it may be difficult for the benchmarks to move substantially higher.

Whatever the major benchmarks do, however, it is entirely possible for one or more industry sectors to buck the trend. Energy stocks rose today as crude oil touched a ten-month high. Analysts are expecting inventories to decline as demand increases later this year, and that usually spells higher prices. As always, we expect energy to be volatile but momentum is still firmly bullish.