The End of Summer

With the forthcoming Labor Day weekend, a rough summer comes to an end for the U.S. stock market. It started out pleasantly enough, with the benchmarks moving higher into mid-July and the Dow and S&P 500 touching new all-time peaks. Yet underneath the surface the subprime mortgage problems were building, and only a month later traders were in near-panic mode as the bond market seized up in a massive liquidity crunch. The benchmarks are now off their lows, but are nowhere near recovering back into bull-market territory. Even long-term trend indicators are on the cusp of turning bearish. The big picture is not encouraging as the vacation season winds down.

Volatility over the last few days has been extraordinarily high. Volume has generally been below average, but the trading that does occur is happening in a herd-like pattern. Lacking conviction, traders are simply following the crowd in whichever direction has the least short-term resistance. This quandary may not resolve itself until the next regular Federal Reserve policy meeting on September 18th. Everyone seems to think a rate cut is just what the doctor ordered and a sharp rally will follow. We won't be surprised to see a big move sparked by whatever the Fed does, but the direction of any such move remains far from certain. If the Fed's action is perceived as weak, even a rate cut could generate another sell-off.

Sector action continues to be choppy with quick rotation in leadership. Energy popped back up in our rankings over the last few days but most energy sector funds are still in intermediate-term downtrends. There are pockets of strength in health care, technology and telecom, while financials, retailers, utilities and homebuilders all remain very weak. In the style categories, a major shift from value to growth is developing, particularly in small caps. This trend may offer new opportunities soon. China-focused international funds continue to dominate the relative strength race, but at the cost of huge daily volatility.

Our next update will be delayed a day due to the Labor day holiday, and will come to you on Tuesday, September 4th.

V O L A T I L I T Y

Market Commentary: We’ve now had five weeks of high-volatility markets with no end in sight. That is not to say that the markets will never again have a period of low volatility, in fact, just the opposite is true. The market has entered a period of high volatility, but there will be additional low volatility periods in the future. Like every other aspect of the market, volatility changes. There are bull markets and bear markets. There are times when growth is in favor and times when value is in favor. There are expanding P/E markets and compressing P/E markets. Yes, there are periods of high volatility and periods of low volatility. The stock market experienced a reversal to the upside on August 16, bringing at least a temporary halt to the decline that began in mid-July. Many technical analysts are now calling for a “retest” of the lows, and if you read between the lines, these analysts almost universally assume that any retest will be successful. Of course, that is not always the case. History is littered with examples of retests that failed, commonly called bear markets. For now, the intermediate trend is down, although that has not yet translated into a long-term downward trend.

The historically narrow credit spread of early June is now a thing of the past. In the process of correcting that narrowness, many bond market participants will agree when we say that things probably went too far and too fast the other direction. The Subprime Slime first pushed the yield on lower quality bonds higher. Then the market seized up and few buyers were willing to step forward, leaving many bond yields “unknown” due to lack of transactions. Meanwhile, the other side of the credit spread was also widening as demand for T-Bills and other government-backed securities caused short-term rates to drop to only 2.4% on August 20. Once again we had credit-spreads out of whack. Volatility is not just a stock market phenomena; the bond market has its share too.

Sectors: Energy, Technology, and Consumer Staples occupy the top spots on our sector relative strength rankings. Their absolute intermediate-term trends can be considered flat at best (low negative absolute readings), but they are the best sectors on a relative basis. The Financial and Consumer Discretionary sectors remain the worst from both an absolute and relative basis.

Styles: It has not been a smooth transition, but the regime shift from Value to Growth seems to be taking hold. Growth was the undisputed king of the late 1990s, and Value has been in charge for most of this decade. Each of the past two cycles lasted about seven years, although there is no guarantee that the pattern will repeat.

International: Our global rankings look as though they contain an error. Our sector rankings are all in the red (negative), our style rankings are all in the red, and our global rankings are all in the red with just one exception – and what a huge exception it is. China is registering enormous upside momentum. Some China funds experienced upside surges of 25% to 30% in just seven market days from August 16 through August 27. Intraday-trading numbers exhibited even larger moves. Granted, they have retreated the past couple of days, and perhaps their decline into the August 16 low was overdone, but the intermediate trend is definitely positive. Volatile, but positive.

Crunch Time

The stock market started a new week on the downside for most sectors and industry groups. Last week's rally brought most benchmarks back up to areas where technical resistance was expected, so the weakness today was not a great surprise. What everyone wants to know, of course, is whether the next big move will be up or down. A period of sideways consolidation is a third possibility, and in our view is more likely than a near-term breakout in either direction.

Bullish analysts, perhaps anticipating further volatility, are now arguing that a retest of the August lows would be helpful in providing the foundation for a new uptrend. This is certainly true, if we assume a retest would be successful. The opposite is also true: a failure to breakout above the July peaks would signal that equities are running out of upside potential. Until the S&P 500 can break decisively above 1560 or below 1375, the next long-term trend remains anyone's guess.

Sector leadership is still rotating quickly. Energy and materials bounced back over the last week, as did technology. These recoveries took place with relatively low trading volume, which suggests they may be less significant than price levels make them appear. Financial services, consumer discretionary, and real estate stocks remain relatively weak. Overseas markets, Asia in particular, staged a sharp rally today. Chinese stock benchmarks are hitting new highs, which is more than you can say for the more-developed markets. Today the SPDR S&P China ETF (GXC) jumped +7.5%.

The news calendar is fairly quiet this week. Ben Bernanke speaks at the annual Jackson Hole economic event on Friday and will be closely watched for hints of future interest rate actions.

Relative Calm

This week the U.S. stock market returned to something resembling normalcy, but it may not last long. All those bad mortgages are still bad. Lay-off announcements in the financial sector are becoming a daily event, and the Bernanke Fed is not yet instilling confidence in its crisis-management abilities. Traders remain reluctant to carry big positions overnight.

After a steep rally from last Thursday's low point, the major benchmarks may have exhausted their short-term momentum. Today the Dow, S&P 500, Nasdaq and Russell 2000 all fell back from early gains to close with small losses. Sector action is still quite choppy. Financials surged higher in the last week on hopes of an interest-rate cut, but basic materials were even more impressive. Today, however, both these sectors were easily overshadowed by energy and technology.

The current market environment is especially challenging for one overwhelming reason: no one knows if, how or when the Federal Reserve may intervene. Of course there are many reasons to be bearish right now. Yet anyone who takes a short position, especially with leverage, could wake up to a rude surprise if the Fed announces a rate cut early one morning. Conversely, if the Fed is unsuccessful in stabilizing the credit markets there is a lot more potential downside ahead. This makes it hard to justify additional equity exposure. So by default many investors are raising cash positions. Not just any cash equivalent will do, however; the market for commercial paper is shrinking quickly. Investors demand the safety of treasury bills, where yields are still substantially lower than they were two weeks ago.

Most investors are currently of a mind to avoid risk. There is more than one kind of risk. There is the risk of being in a market that is heading down, yet there is also the risk of not being in a market when it goes up. The best strategy is to balance these two types of risk, which is why our model portfolios currently hold a mixture of cash and equity funds.

Follow the Money

The big news today is the purchase by Bank of America (BAC) of $2 billion in preferred stock in the beleaguered Countrywide Financial (CFC). Deals like this are not made overnight, which leads us to think it has probably been in the works for at least a couple of weeks.

Now it so happens that other unusual things have taken place in the markets during this time - some publicly known, others not. Follow the sequence of events and an interesting conclusion emerges.

8/15 - Merrill Lynch analyst says CFC is in danger of bankruptcy.
8/16 - Countrywide taps all its available credit lines, total $11.5 billion.
8/16 - Fitch and Moody's cut Countrywide credit ratings.
8/17 - Bank of America Securities analysts (who once worked at Countrywide) upgrades CFC.
8/17 - The Federal Reserve cuts the Discount Rate and eases collateral requirements.
8/17 - Morgan Stanley downgrades CFC.
8/20 - Countrywide begins staff layoffs.
8/20 - KBW downgrades CFC.
8/21 - Rumors abound that Warren Buffet is looking at a Countrywide acquisition.
8/22 - Four mega-banks borrow $500 million each from the Fed's discount window.
8/22 - One of the four, JP Morgan (JPM), upgrades CFC.
8/22 - Another of the four, Bank of America (BAC), buys $2 billion in preferred stock from CFC.

A number of curious things are going on here. First, while CFC's very survival was in doubt the BAC analyst still found reason to upgrade it.

Second, the four large banks borrowed from the Fed's Discount Window at a rate of 5.75%, even though they are perfectly capable of financing their normal cash needs at the 5.25% Fed Funds rate. Why pay a premium? It was explained that they wished to show confidence in the Fed and demonstrate that smaller banks need not fear that use of the Discount Window would be perceived as a sign of weakness.

This explanation does not pass the laugh test. These banks are publicly traded companies. They owe their shareholders a duty to obtain the best possible financing terms. Paying an extra 50 basis points when they don't need to, and then announcing it publicly, is financial malpractice and an invitation for shareholder lawsuits. The executives know this so they must have had other reasons.

This brings us to the third curiosity: soon after the banks borrow a total of $2 billion from the Fed (remember that number, by the way; you will soon see it again), an analyst for JP Morgan upgraded CFC. Two and only two analysts on the Street upgraded CFC in the last week. Both happen to be attached to banks that borrowed from the Fed on unusual terms.

Fourth and finally, Bank of America buys $2 billion in CFC preferred stock. Wall Street breathes a sign of relief that the crisis has passed. No one seems to notice that CFC's windfall happens to be the exact same amount of money that the Fed just loaned to a consortium of megabanks.

Conclusion: the Fed has bailed out Countrywide, using BAC and the other three megabanks as a conduit. The other $1.5 billion will find its way, via circuitous routes, from the other three banks into the BAC vaults. BAC is taking no risk in this deal because they are playing with the Fed's money.

Even before the Fed acted last week, the wheels were already in motion for this deal to come together. Either that, or this is all a series of really remarkable coincidences.

If in fact the Fed is trying to bail out Countrywide, there's a good chance it will take more than $2 billion. We may see more such exotic financing in the near future, or possibly they are also acting in other ways that are not yet apparent. In any case, having tried to do this the Fed cannot afford to fail. It would be a fatal blow to Bernanke's credibility. The stakes are huge.

Relief Rally

Market Commentary: The four-week selling spree accelerated last week, hitting its nadir mid-day on Thursday. Thursday’s dramatic turn-around seems to have put a short-term bottom in place for now, boosted by the Fed’s decision to cut the discount rate by 50 basis points on Friday. Markets have been staging a relief rally – relieved that the Fed is paying attention. Perhaps we may be able to call it something stronger than a relief rally in the near future, but for now, that is all that it is.

While the Fed action was well received by the equity markets, the credit markets (which the action was “supposed” to address) remain in a quagmire. There are still few buyers for non-government debt instruments, and on Monday, the demand for short-term Treasuries was so great the yield dropped below 2.5%. It has now returned to around 3.5%, the same place it was last Thursday.

Sectors: All sectors remain in intermediate-term downtrends while trying desperately to rebound from last week’s turmoil. In what is considered typical action, the sectors that were beaten down the most have bounced the highest, so far. Needless to say, the Financial sector has been at the forefront of this action. The relative volatility in the Financial sector has reached historic levels, with prices jumping more than 10% from Thursday’s mid-day low to Friday’s opening high. Without any follow through on this brief surge, our outlook remains negative on Financials. The Materials sector also sold-off sharply last week and staged a rally of nearly 10% to coincide with the move in the Financial sector. The major difference is that Materials has now surpassed that Friday morning level, providing it with better odds for a successful recovery, although that is not a given at this juncture.

Styles: High levels of volatility have also been the norm among the various styles lately, although nothing quite as extreme as we have seen in the sectors. Growth still has the edge over Value for now, but that could change in a heartbeat.

International: Correlation increases during market declines, and that was clearly evident this past week. Global markets sold-off sharply in the face of what is viewed mostly as a U.S. problem, indicating that global markets are linked more than ever. Emerging equity markets underwent the steepest declines, especially Latin America. Believe it or not, our domestic markets have actually held up the best, vaulting them to near the top of our global rankings over the past few weeks.

Rush To Safety

As you no doubt heard, last Friday morning the Federal Reserve reduced its Discount Rate and took some other measures to encourage the credit markets. The Discount Rate is not near as important as the Federal Funds rate, which was left unchanged. It was, in our view, a largely symbolic act designed to send a message that the Fed is not asleep at the wheel. If so, it had the desired effect - for about a half-hour. That was how long it took Friday's opening rally to top out.

Today brought another surprise. The 3-month Treasury Bill yield is a widely used benchmark for short-term loans, and it also serves as a kind of proxy for cash-equivalent assets. This time last week, it stood at 4.7%. Today the same T-Bills traded for a yield as low as 2.5%. This is an unprecedented drop, far exceeding what happened even in previous market panics such as October 1987. A fall in the T-Bill rate means that investors are willing to pay almost any price for safety. Please note, most of this decline happened today, after the Fed supposedly rescued the markets. Clearly some people are not yet convinced.

We were actually quite surprised when the Fed acted on Friday; our feeling was that Bernanke would let Wall Street fend for itself rather than risk inflation and possibly damage his own credibility. Now it appears that the main thing the rate cut accomplished was to demonstrate that the Fed is just as clueless as everyone else. The policy statement from the last Fed meeting on August 7 is now meaningless, and no one knows what kind of policy will come out of the next meeting on September 18. This creates a situation of enormous uncertainty. As a result, markets will likely remain very volatile for the new few weeks.

Sector action remains choppy. Financials, consumer discretionary, materials and real estate remain the weakest sectors, but other than T-Bills nothing is particularly strong right now.

August Lows Taken Out to the Woodshed

Market Commentary: The stock market sell-off continues with little end in sight. Today the Dow and S&P 500 both broke below their August lows. Long-term trend indicators are beginning to turn decisively bearish, which may lead to even more selling pressure in the near future. Wall Street is increasingly shrill in its attempts to jawbone the Fed into a rate cut. Ben Bernanke does not seem inclined to accommodate; the much-heralded injections of liquidity in the last few days were really quite small. The Fed is still focused on getting inflation back down to its target rate of 2%. If that means a few more hedge funds have to blow up, we think Bernanke is prepared to let them do so.

Treasury bonds are quickly becoming the asset class of choice for legions of former equity investors. Anyone who needs liquidity right now has little choice but to get it by selling stocks. With no one willing to take on any kind of credit risk, the non-government bond markets have largely ground to a halt. The great fear now is that the much-publicized subprime problems are only the tip of the iceberg. The decision by a Chicago cash-management firm called Sentinel Management to suspend redemptions for its investors is causing open speculation that one or more money-market funds may “break the buck..” So far we see no hard evidence of such a thing, but it can’t be ruled out. Whatever the underlying fundamentals may be, financial markets are in a panic mode right now. People are doing irrational things, which means anything can happen. Cash is the king for now.

Sectors: Those sectors that were still holding slightly positive in our momentum ratings (Technology, Consumer Staples, Energy) turned negative over the last week but are still stronger than anything else. Financials and Consumer Discretionary, and to a lesser degree Materials, deteriorated further and maintained their rankings at the bottom of the list. Sector action continues to grow more and more characteristic of a defensive, almost recessionary equity market. If this trend continues, we would look for Technology to lose some of its strength while Health Care gains ground. Financials are now to the point that a recovery may take months or even years. Due to its large capitalization, this sector will act as an anchor holding back the cap-weighted market benchmarks for some time to come. The good news is that we will likely have more opportunity to add value through sector rotation in the coming months.

Styles: The picture grew increasingly bearish this week as Mega-Caps gave up their top ranking to Small Growth, which itself lost momentum in absolute terms. The blue chips had been the last refuge for equity investors; the fact that they are now breaking down suggests we may be getting close to a capitulation low. It does not necessarily follow that a recovery will quickly follow, however. At the other end of the scale, Micro-Caps slowed their decline a bit but remain in a firm downtrend.

International: Global markets turned further negative, with all except China now showing negative momentum. Even China is decelerating quickly and will likely enter its own downtrend soon. The good news is that the U.S. improved its relative position against other markets over the last week. The bad news is it did this only because foreign markets, notably Europe, Latin America, and Japan, were losing ground even faster than the U.S. The liquidity crunch is clearly global in scope, and we are learning that European institutions were apparently heavy buyers of U.S. subprime debt. U.S. investors looking for a safe haven are not finding it overseas.

Looking For Help

The major stock market benchmarks are little changed since last Thursday's big drop. This may have something to do with the Federal Reserve's decision to provide extra liquidity in the bond market. The European Central Bank made a similar move the day before. The amounts involved are not huge in the grand scheme of things. Yet such actions have symbolic value in reminding traders that the central banks aren't asleep at the wheel.

Pundits in the media continue to snipe at the Fed for not cutting rates at last week's policy meeting, and many are now calling for Bernanke to take the unusual step of announcing a rate cut before the next regular meeting, scheduled for Sept. 18th. We suspect this is wishful thinking. First, Bernanke does not seem to be terribly concerned about pleasing the media, or Wall Street for that matter. He has the bigger picture in mind. Second, the Fed's job is to maintain a balance between inflation and recession. Years of strong economic activity and historically high energy prices give Bernanke little room to maneuver on the inflation side of the ledger. If he has to choose, we suspect it will be in favor of slowing down the economy. That argues against lower interest rates. At this stage a rate cut would simply trade short-term relief for more long-term pain.

A look at our Fidelity Select rankings today is interesting. First, notice how the various financial services sector funds are clustered at the bottom of the list. Banks, brokers and mortgage lenders have been decimated in the last few weeks. Fortunately we haven't had any exposure to that group. Only two funds have a 15-day return that is greater than zero. One is a money market fund. The other is Fidelity Select Medical Equipment (FSMEX).

Spreading Infection

The near-panic about subprime mortgage problems seemed to be fading this week, with three days of strong gains bringing the benchmarks nearly halfway back from their losses. All that changed today when a large French bank reported that some hedge funds it sponsors may have experienced major losses in mortgage securities. A problem that appeared to be mainly restricted to the U.S. suddenly started to look like a global crisis. The European Central Bank injected liquidity into the market on a massive scale, but overnight interbank lending rates still soared.

Meanwhile, there were signs in the U.S. that financing problems may derail some of the recent private-equity transactions that have propped up stock valuations. Home Depot (HD) scaled back plans for a stock buyback. Risks are growing for corporate bonds as banks tighten their credit standards and ratings agencies place many bonds under review. Treasury bonds again rallied as capital from around the globe sought a safe haven. Falling crude oil prices again cut into energy sector earnings, removing one of the market's recent leaders.

There is growing concern that the Federal Reserve may have erred by declining to reduce interest rates at its meeting earlier this week. Ben Bernanke has consistently argued that Fed policy decisions should be made slowly and deliberately, not in reaction to market events. With energy prices at historically high levels, the Fed does not have a lot of room to maneuver right now if it wants to keep inflation under control. Nonetheless, the futures markets now indicate a near 100% consensus that the Fed will cut rates in October.

A Wild Ride!

Market Commentary: Equity markets continued to decline last week, with the sell-off accelerating into Friday’s close. The market had been reluctant to establish a bottom during this two-week pullback, but that final wave of selling on Friday seemed to do the trick, as there was not any follow-through on Monday morning. In fact, equity markets have been heading nearly straight up since shortly after Monday’s open. Analysts were quick to suggest that the positive action that began on Monday was nothing more than short-covering prior to Tuesday’s FOMC meeting. However, with that meeting now behind us, and the market advance continuing today, many of those same analysts are now suggesting that it could be more than short-covering.

Government bonds had been moving upward the past couple of weeks on hopes that the Fed might drop some hints of future easing possibilities given the mess that had developed in the subprime arena. Those hopes were apparently dashed when the Fed failed to deliver those hints, and the 10-Year Treasury yield jumped to 4.87% today. The recent sell-off in high-yield bonds created some selective bargains, which has helped stabilize that market for now. However, a high level of uncertainty still permeates this space, and we suspect that additional unwinding is yet to come.

Sectors: The Financial sector has grabbed most of the headlines this past week, and for good reason. Financials are the largest sector of the cap-weighted S&P 500 index and therefore the most influential in determining the course of the S&P. The five-day performance of the Financial Select Sector SPDR Fund was a solid +3.2%. This is even more impressive given the fact that it declined -4.3% on Friday, putting it down -15.2% from its recent peak. The Financial sector remains at the bottom of our relative strength rankings, but it is one of the few sectors that improved its “absolute” momentum score this past week.
The Energy sector also received its share of headlines this week as the price of crude oil declined rapidly after hitting a new high a week ago. As a result, Energy and the Energy Services subsector are posting dismal one-week results, and Energy has relinquished its top spot in our sector rankings to Industrials.

Styles: A few days down and a few days up, but not much has changed in our style rankings. Mega-Caps and Large-Cap Growth continue to be the best performing styles, offering a relative safe-haven throughout this recent market turmoil.

International: International markets have been taking their cue from the USA lately, which has resulted in an overnight time delay in much of the daily action and results. While many international mutual funds are posting negative one-week results, we suspect that this could improve significantly when measured again tomorrow. Meanwhile, China still commands the top position in our global equity rankings.

Out of Energy

After another big drop on Friday, stock market investors were on guard for big losses today. Instead the benchmarks soared higher. As impressive as today seemed, it really brought the major benchmarks and sectors back to where they were in the middle of last week. We suspect much of today's action was short-covering ahead of tomorrow's Federal Reserve policy meeting. Economists expect the Fed to leave rates unchanged but will look for signs that a rate cut is under consideration for later this year. Depending on the Fed news, more volatility is likely tomorrow afternoon and Wednesday.

As of last Thursday, the energy service sector still looked likely to recover from its recent downturn. Our indicators changed drastically after Friday's loss and did not improve today. Crude oil prices have dropped over 8% since an all-time high reached on August 1, including today's 4.5% decline. Rapidly spreading losses in the mortgage market, along with other economic data, are leading investors to think U.S. economic growth will slow significantly in the next few months. This would reduce the demand for energy, and thus energy prices are falling with energy-related equities not far behind.

To say this market has been a challenge would be an understatement. We have to strike a balance between staying flexible and maintaining our strategic discipline. As always, we look to the market itself for guidance. Over the years, it has been the best guide we know.

Encouraging Signs

The Wall Street selling frenzy resumed this week, reaching its apex on Wednesday afternoon. A last-minute wave of buying brought the day's closing numbers into a more respectable range and set up today's gains in the major benchmarks. Perhaps the low is now behind us, but we have not yet seen anything that looks like "capitulation" selling. More short-term weakness won't be surprising.

An encouraging sign is that the S&P 500 successfully tested its 200-day moving average and appears, albeit slowly, to be climbing back into more bullish territory. The long-term uptrend remains intact. Nonetheless, short-term and intermediate-term indicators are bearish and it may take some time, and more downside, before the benchmarks once again see new highs.

The Streak Ends!

Market Commentary: Equity markets continued their short-term downtrend this past week. However, they did so with such a vengeance that the intermediate-term trends also turned negative. The weekly see-saw market reversal pattern we have been following failed to extend its run, ending the streak at 14 straight weeks. This was just another example of how random events can take on the appearance of non-randomness and a gentle reminder that all streaks eventually come to an end.

Government bonds had a good week, but the vast majority of the move was confined to just one day (last Thursday) when the 10-Year Treasury yield dropped from 4.90% to 4.76%, which is where it sits today. The subprime debacle has created a huge cloud of uncertainty in the credit markets. No one knows for sure how widespread, or how contained, the problems really are. As a result, government issues are being treated as the only sure bet.

Sectors: Crude oil hit a new high today near $79 per barrel before reversing and ending the day on the downside. The bullish action in crude oil this week did not translate into gains for energy related equities, as the Energy sector got caught up in the global equity weakness. Although none of the sectors were spared from the selling that took place, their Relative Strength relationships remained pretty much intact. If there is an exception to that statement, it would have to be the Materials sector which dropped two levels in our rankings. The March support level for the Financial sector crumbled this past week, and Consumer Discretionary broke its support today. The Utilities sector is right at its March support while the remaining sectors have so far managed to keep themselves above their March lows.

Styles: Our style rankings accurately reflect the recent market action. The Micro-Cap segment has been one of the worst areas to be in, and this group has now broken below its March support level. None of our other “style” categories has taken out their support, but Small-Cap Value and Small-Cap Blend are getting close. Mega-Caps and Large-Cap Growth have held up the best.

International: International markets did not escape the carnage this past week, and many regions underwent more severe trauma than our domestic markets. Latin America, Pacific x-Japan, and other Emerging Markets took the biggest hit. They also staged above-average recovery attempts on Monday before heading back down again. Volatility was high in domestic markets this past week, but it paled in comparison to that of the various Emerging Markets. Japan jumped from the bottom to about the mid-point of our global rankings, while the U.K. slid down to grab the bottom spot.