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.