Signs of Life

The U.S. economy grew at a 3.8% annual rate in the second quarter of 2007, the government reported today. This was a substantial increase from the 0.6% rate posted in the first quarter, causing some to feel a little more optimistic about avoiding recession. Unfortunately, the report does not reflect events from July 1 to the present, a period in which the housing market's downturn accelerated. Indeed, a separate report today showed that new home sales fell 8.3% in August, and the median sales price dropped by 7.5% from a year ago. This was the steepest plunge in housing prices since 1970.

Clearly, then, the housing sector has not yet hit bottom and may not do so for a long time. So why are stocks going up? The stock market appears to have accepted facts and is in the process of adjusting itself to a different environment. Financial services and consumer discretionary stocks are the losers in this scenario, along with the homebuilders themselves. Who wins? No one, really, except for the fact that the Fed's interest rate cuts have sparked inflation fears and a flight out of the dollar and into commodities and foreign markets. Hence we see major rallies in energy, gold, and emerging markets.

The stock market has been called a giant discounting mechanism. It values companies based not on their current condition, but on a consensus outlook for their future prospects. This year's reality matters less than next year's forecast. Whatever else is going on in the world, the market consensus appears to be that aggregate corporate profits will remain generally strong. There is a great deal of variation within the benchmarks because some companies and sectors are expected to do better than others. In the big picture, however, the prognosis looks a lot brighter than it did a few weeks ago. Hence we see the benchmarks moving back up toward their recent highs. Whether they will be able to break through is the next big test. The Nasdaq 100 is already above its July peak; the Dow and S&P 500 need to follow soon.

Holding Steady

Market Commentary: Volume is starting to pick up again now that the Fed has come to the rescue. August is typically one of the lowest volume months of the year. August 2007 was an exception, an extreme exception. Monthly volume for the NYSE and Nasdaq both hit new lifetime highs. Unfortunately, the vast majority of that volume came on the downside, leaving those huge volume spikes painted red on computer terminals across the country. During the last half of August, the seasonal reduction in volume did return. Volume typically picks up within a week after Labor Day, but that was not the case this time. It wasn’t until the FOMC meeting last week that volume started to return to the market. The markets haven’t staged a significant follow-through since the Fed-inspired action of last week. However, it is encouraging that the markets haven’t really given back anything either.

The Fed action has steepened the yield curve through changes at both ends of the maturity spectrum. Short-term rates and 2-year yields have dropped, five-year rates are essentially the same as they were before the meeting, but 10-year and 30-year yields have increased. If the Fed action was meant to help consumers, the opposite has happened. If it was meant to help banks that borrow short and lend long, then they should indeed reap some benefits.

Sectors: On a relative basis, very little has changed for sectors over the past few months. The strongest in late June are still the strongest today. The weakest in June are still the weakest today. On an absolute basis, all the sectors went through significant changes. All were strong in late June, most were weak in mid-August, and most have regained their strength here in late September.

Styles: There has been some minor jockeying for position in our style rankings, but the overall theme remains the same. The market is currently favoring Growth and Large Cap while shunning Value and Small Cap.

International: The performance of the Chinese market is putting the rest of the globe to shame. However, with an intermediate-term momentum reading of 138, China is certainly extended, and perhaps frothy.

Fed Rally Fading

Last week's Fed-inspired stock market bounce appears to be slowing down. It is possible that a brief pause will refresh the forces of bullishness and allow the benchmarks to break out to new highs. It is also possible that lower short-term interest rates will turn out not to be the economic panacea some expected. The Fed has administered medication with significant side effects that may or may not be tolerable. Long-term interest rates, for example, surged as it became clear that Ben Bernanke is not quite the inflation hawk he used to be. For example, stressed homeowners who thought they could refinance their adjustable-rate mortgage to a 30-year fixed-rate loan are finding that option is no longer as attractive, if it is available at all.

In the economic big picture, lower interest rates mean a bigger money supply. More dollars in circulation means that each dollar is worth a little less than it used to be, as compared to other currencies or to tangible goods. This phenomenon is called "inflation" and the markets seem to be anticipating more of it in the near future. Gold and crude oil shot up in the last week for that very reason. Gold is perhaps a better proxy for the monetary aspects of inflation, but energy may have more upside. Consumers around the globe who have little use for gold coins and jewelry have little choice about buying petroleum-based products. Rising prices the last few years have shown little impact on overall demand. With Treasury futures trading indicating that more rate cuts are likely, the downtrend in the dollar and concomitant uptrend in commodities seems likely to be with us for some time.

Shock & Awe?

Market Commentary: The most highly anticipated FOMC meeting in recent memory is now in the history books. Choosing to sacrifice the threat of inflation over market liquidity concerns, the Fed lowered both the Federal Funds Rate and Discount Rate by 50bps. This appeared to be what the market was looking for, and perhaps even more. Equity markets responded positively around the globe.

Although the Fed has lowered interest rates, the yield on the 10-year Treasury has climbed significantly the past eight trading days from 4.32% to more than 4.52%. The new level is slightly higher than the 4.49% level that prevailed prior to yesterday’s announcement. So far, the interest rate reduction has not filtered through to intermediate and long-term government securities, but don’t tell that to equity investors.

Sectors: All sectors received a boost this week with the most depressed (Financials and Consumer Discretionary) receiving some of the biggest bounces. The change in the environment has helped these groups, but the rate cut is an acknowledgment that these sectors are in trouble. Lower interest rates may also provide additional weakness for the US dollar and carries inflationary concerns. These factors help improve the outlook for the Materials sector, which has jumped back into the number two slot in our sector rankings.

Styles: The various investment styles are virtually unchanged from a relative ranking this week, but they all improved their absolute standing considerably. Mega Cap and Large Cap Growth remain the favorites while Micro Caps and Small Cap Value trail the field.

International: What’s good for the US is great for the world, or so it seems. Most of the globe got a good pop this week. The notable exception is Japan, which is mired in its own problems.

Waiting for Tuesday

Each Monday the Wall Street Journal provides a little day-by-day list of important events for the coming week: earnings announcements, economic data releases, etc. It is a nice feature that helps traders know what to expect. This week's version includes the usual minutiae, but might just as well have a single entry: "Tuesday, 2:15 Eastern Time, FOMC announcement."

FOMC stands for Federal Open Market Committee, the group which decides on the Federal Reserve's interest rate policy. Wall Street is certain this meeting will end with a rate cut and debates only whether it will be one-quarter of a percentage point or half a percentage point. Chairman Ben Bernanke and his colleagues are well aware that the market will not appreciate any surprises. Since they have not tried to signal any disagreement with the prevailing expectations, a rate cut of some degree seems very likely. More important will be the accompanying statement that may provide clues to future Fed policy.

Reaction to whatever the Fed does is difficult to predict. Indeed, with such widespread consensus it seems almost certain that the impact of a rate cut is already baked into asset values. It is hard to imagine anything the Fed could say or do that would create a bullish reaction for stocks - but Bernanke may have tricks up his sleeve we don't yet know about. The recent rise in commodity prices, especially oil and gold, and a concurrent decline in the dollar and yen are almost certainly related to the impending Fed action.

Across the Atlantic, a bank in the UK called Northern Rock is experiencing an old-fashioned bank run. The Bank of England bailed out Northern Rock last week, but customers are are still lining up (or "queuing" as the British like to say) to withdraw their deposits - to the tune of about $4 billion so far. This is minor in the grand scheme of things, but a troubling reminder of how some institutions may be close to the edge.

As a measure of how fixated the markets are on tomorrow's decision, consider that today's NYSE volume was the lowest for a full trading day so far this year. Clearly investors are in wait-and-see mode, and wisely so. Stay tuned for an interesting week.

Holding Pattern

A three day rally brought the U.S. stock market back near the top of its short-term trading range. An interesting chart pattern has developed in the S&P 500 over the last four weeks. Intraday high and low points show, since August 16, a series of lower highs and higher lows. In other words, stocks are trading within an increasingly narrow channel. One trendline or the other will have to break soon.

We suspect this quandary will be resolved through the catalyst of next Tuesday's Federal Open Market Committee meeting. Trading in the futures markets indicates a high probablity of a 50 basis point cut in the Federal Funds rate, from the current 5.25% to 4.75%. Anything less will be considered a disappointment. Fed Chairman Ben Barnanke and the other committee members haven't dropped very many hints, which suggests the market is probably guessing right. Pundits are now turning their attention to the impact a rate cut will have on the U.S. dollar. It won't be good, but the question is whether the effect is already reflected in exchange rates.

A weaker dollar is typically good news for commodity prices. This may be why crude oil rose to a new record high on Wednesday, briefly trading above $80. Energy-related equities, while picking up some momentum, still remain well below their July peaks. Gold has also popped higher, moving above $700 and sparking a rally in gold stocks. Fidelity Select Gold (FSAGX), for instance, jumped from # 25 in our momentum ratings this time last week to # 2 in today's table. We've seen it move just as quickly in the other direction, though, so we are not ready to buy gold funds just yet.

FOMC and Triple Witching Next Week!!

Market Commentary: The market recovery lost some steam this past week, but it hasn’t given up. Even though the rally stalled as the 50% retracement levels were reached, it would be premature to say that the rally has failed. The day-to-day action appears to be news driven and remains highly volatile. Equity traders are putting a large amount of emphasis on the upcoming FOMC meeting, and volume is expected to be light leading up to that event.

During times of commercial paper liquidity problems, the Fed has historically used the Discount Rate as the intervention mechanism. Greenspan bucked tradition by ignoring the Discount Rate during his 18 years at the helm. Bernanke has reinstated the use of the Discount Window in an attempt to separate the dual roles of the Fed: maintaining financial stability and controlling inflation. In the meantime, the bond market appeared to shrug this off, and futures traders are predicting a 74% chance of a 50bps cut to the Fed Funds rate next week. The September 18 FOMC meeting might be a meeting to remember. The Fed is receiving pressure to cut the Fed Funds rate in an effort to help the liquidity problems brought on by the subprime slime. Bernanke has made it known that he believes the Discount Rate is the appropriate mechanism for this particular concern. His resolve will be put to the test next week. He can hold his ground and leave rates unchanged, or he could attempt to appease the masses by cutting the Fed Funds rate. He could also do a little of both: cut the Fed Funds Rate but claim that heading off a recession is now a higher priority than keeping inflation under control, instead of saying that it is to address credit liquidity concerns. Meanwhile, the 10-year Treasury yield dropped as low as +4.30% on Monday (down from 5.3% in June) before moving back up to +4.41 today.

Sectors: We have a wide divergence in sector strength at the present time. There are two strong sectors, two weak sectors, and the rest are in the neutral range. Energy and Technology are the two strong sectors. Oil prices are again at new highs, and the Technology sector has successfully separated itself from the credit crunch. The weak sectors are Financials and Consumer Discretionary, a dubious honor they have held for quite a while. Real estate and the mortgage lending business are at the epicenter of the credit problems, and they are both part of the Financial Sector.

Styles: History does repeat itself, but sometimes the names are changed to protect the guilty. In 1999 it was widely believed that Large Cap Growth was all anyone needed. At that time, Large Cap Growth was the best performing style for the most recent 5-years and almost every other time-period you could imagine. Small Cap Value was at the other end of the spectrum. Last year we found those roles reversed. Investors were chanting the Small Cap Value mantra, as it was the new style king for 5-year performance (along with almost every other time-period you could imagine) while Large Cap Growth was at the other end of the spectrum. Styles rotate. Small Cap Value is now weak and getting weaker. It would not surprise us to see Small Cap Value at the bottom of the 5-year performance charts five years from now. We don’t know who will be on top, but the odds are in favor of Growth being part of its name.

International: Same song, different verse. China, and the rest of Asia excluding Japan, continue to provide global leadership. The “developed” markets of Japan, the USA, and the European Union are lagging.

Losing Jobs

Friday's weak jobs data, which we said in our last update could be pivotal, was unexpectedly weak. Economists had forecasted nonfarm payrolls would grow by 92,000 in August. The report revealed that the number of jobs actually fell by 4,000 instead. This was the first decline in jobs since August 2003. Moreover, job growth for July and June was revised downward.

Prior to Friday morning, the stock market was in its usual bad-news-is-good-news mode. If the economy is weak, the thinking goes, the Fed is more likely to cut interest rates, which is bullish for stocks. Something seems to have changed in market psychology in the last few days. Forecasts of a recession are no longer being greeted as welcome tools in the quest for lower interest rates. Bad news is now seen as simply bad news.

However you want to interpret it, the jobs data took wind from the sails of a stock market that had been trying to pick up momentum. In hindsight, it appears more likely to have reached the top of a trading range and is now exploring for a bottom. Today brought a small gain for the Dow and modest losses in broader benchmarks like the S&P 500 and Nasdaq Composite. Health care, utilities and consumer staples - the classic defensive sectors - were positive for the day while real estate, materials and industrials fell. On an intermediate-term basis, energy and technology remain the strongest sectors.

Dueling Data Points

The stock market seems to be back in data-dependency mode, results on any given day being based largely on whatever new economic and corporate data is hitting the newswires. Today was a good example. The day opened with much attention being paid to retail sales. The International Council of Shopping Centers, based on results from 47 retailers, said that August sales rose 2.9%, significantly ahead of projections. Wal-Mart (WMT), Target (TGT) and other chain stores also reported brisk back-to-school sales for the month. This suggests that consumer spending may remain strong despite the real estate downturn. On the other hand, the Mortgage Bankers Association said today that foreclosures and delinquencies are at record highs. Almost 15% of all subprime mortgages are late making payments. It's hard to see how that is good news for anyone.

Meanwhile, various Federal Reserve officials presented various opinions about the economy today, leaving observers no more enlightened than before. The consensus of today's speeches seems to be that the Fed may need a little more convincing in order to deliver a rate cut at its next meeting; none seemed to think that the housing slowdown has yet spilled into the broader economy. A flight-to-quality in the bond market remains in effect, with 10-year Treasury yields dropping fast and widening spreads with corporate bonds both in the U.S. and Europe.

Gold moved above $700 today for the first time since May, while crude oil traded above $77 before pulling back. With the Fed and other central banks acting to increase market liquidity, money-supply figures seem likely to increase. In that scenario commodity prices tend to rise. Other supply and demand factors are still relevant, of course, but all other things being equal monetary expansion is bullish for commodities. This is another factor arguing against an interest-rate cut.

Tomorrow brings the August unemployment and payroll data. This is always a critical report, and for seasonal reasons August tends to be weak. The consensus among economists is that nonfarm payrolls grew by just 92,000 in August. A lower number might be short-term bullish if it gives the Fed another reason to cut rates. With another seven market days to go before the Fed meets on September 18th, however, this number may be long forgotten before it matters.

50% Retracement

Market Commentary: Roughly half of the recent correction has now been recovered. This is called a 50% retracement and is considered typical action in financial markets. The recovery attempt stalled, or ran into resistance, late yesterday and today with many broad domestic market indexes trying to retake their 50-day moving averages. This is also considered typical action for financial markets. Volume has been lackluster during the two-week recovery, which tends to reinforce the stalling action. Volume is expected to start picking up soon as the seasonal slow period is now behind us. During the month of August, volume was a significant factor during the downswing and was noticeably light on the upswing. Now we will see what September brings.

The bond market is still mired in the process of sorting out the quality issue. There are still large pools of debt instruments labeled “unknown” with pricing that reflects that uncertainty. At the recent height of the liquidity crisis, it appeared that the only distinction being made was government or non-government. Now some level of order is being restored to some segments of the bond market. As a result, prices are drifting upward on lower quality bonds that can be separated from subprime slime. A Fed rate cut is being taken for granted later this month. This coupled with today’s release of the beige book pushed the 10-year Treasury yield down to +4.473% today, a new low for 2007.

Sectors: A 50% retracement is also common among sectors. However, we typically see a wider divergence of results here. Technology, Energy, Industrials, and Telecom are currently exhibiting a 50% or better retracement and are performing above average. The retracements for Financial, Consumer Discretionary, Health Care, and Utilities have fallen far short of the 50% mark, indicating significant weakness. These results are also reflected in our relative sector rankings.

Styles: The style segments have also had two weeks of recovery with non-uniform results. As indicated by our relative style ranking chart, Mega Caps and all forms of Growth have achieved a 50% retracement level, while the Micro Caps and Value have failed to do so.

International: The 50% retracement phenomenon is not limited to domestic markets. Most global markets have also traced a similar pattern the past two weeks. The most notable exceptions are Japan, which has fallen far short of the 50% level, and China, which raced to a new high more than a week ago.

Bull and Bear Stand-Off

For a time today, it seemed that investors had collectively decided the market waters were once again safe and a major upside rally would develop. Such hopes faded into the close, though the day still ended with solid gains in most benchmarks and sectors. Some technical indicators are turning more positive. The S&P 500 and Dow Jones Industrial Average both closed just above their 50-day moving averages and the Russell 2000 is not far behind. We will have to wait and see whether this level becomes a barrier to further progress.

A few points of concern remain. The recovery of the last two weeks has yet to attract trading volume comparable to the preceding declines. Economic indicators continue to point toward a significant slowdown at best, and possibly a recession. The housing sector is still in serious trouble. Most important, it is an open question how the Federal Reserve intends to proceed in adjusting monetary policy. Many people are assuming that a Federal Funds rate cut is all but guaranteed at the next Fed meeting on September 18th, if not before. If that assumption proves wrong, or even if it proves right, the second half of September is likely to bring further volatility. A re-test of the August lows would actually be a positive event if it is successful, but we suspect few people will think that way if it happens.

Energy stocks surged higher today, though we are not quite sure why. Economic weakness would seem to be bearish for oil prices, but the market appears to have reached a different conclusion, at least for today. Utilities, REITs, and technology all picked up some positive momentum day. A slightly longer perspective reveals that energy and technology are, by a significant margin, the strongest sectors right now. Financials are still struggling to recover lost ground.

The overall picture is of a narrow rally on average volume. Bull markets are said to climb a wall of worry, of course, and all the problems we have mentioned can be overcome. The question is how long it will take.