Crunchy Credit

If humility is a virtue, then the leaders of Citigroup may be some of the more virtuous people in New York. This week they agreed to sell $7.5 billion in convertible stock to an investment fund controlled by the government of Abu Dhabi, one of the United Arab Emirates. The terms of the transaction are complex and it is not entirely clear who gets the best end of the deal. Nonetheless. it is hard to portray as anything other than a bailout. Citigroup is, in effect, borrowing money at an 11% interest rate and giving up a 4.9% equity stake. A Wall Street Journal editorial summed it up well, saying "it strikes us as unfortunate, if not a tragedy, that America's largest bank had to go hat in hand to Arab sheiks because of bad management and blundering U.S. monetary policy."

Having been reduced to nothing less than a subprime borrower itself, Citi and its peers are increasingly selective about lending money to anyone else. The resulting "credit crunch" threatens to push the economy into recession. The fact that year-end is approaching exacerbates this situation, as lenders are reluctant to acquire new loans that will have to appear on their December 31 balance sheets. This suggests the situation may ease in January; whether it will be enough to matter is impossible to say at this point. Consumers who face a softening job market, rising fuel and food costs, falling home prices and tighter interest rates can hardly be blamed if they decline to stimulate the economy with exorbitant holiday spending.

With all this going on, why did the stock market stage a major rally on Tuesday and Wednesday, then hold on to its gains today? The market is back in "Bad news equals good news" mode. Traders are betting that economic weakness will allow the Fed to keep dropping interest rates, and Fed officials are dropping plenty of hints to support this notion. Meanwhile, a pullback in oil prices suggested inflation pressure could ease. This week's equity gains can easily be characterized as nothing but an "oversold bounce," and unless there is more follow-through soon it will become difficult to argue otherwise.

Taking a step back, intermediate-term relative strength is largely unchanged despite all the fireworks. The defensive trio of utilities, consumer staples and health care is still the place to be for equity investors. Selected foreign markets remain in uptrends but show signs of weakening.

Vroom Vroom

Market Commentary: If you listen closely, that sound you hear is the collective sigh of relief emanating from Wall Street. Yesterday’s upward move was widely welcomed. Today’s upward move was a happy turn of events. However, that does not mean it is time to throw caution to the wind. After all, it has only been two days, and with most market benchmarks still below their 200-day moving averages, there remains much damage to repair.

The 10-year Treasury yield plunged this past week, hitting a low of 3.85% before moving back up to close at 4.02% today. The 3.85% level was its lowest in nearly two and half years and was a reflection of recession fears. Analysts are crediting today’s upside move in equities, as well as Treasury yields, to comments from Fed Governor Kohn that indicate further interest rate cuts are indeed a possibility.

Sectors: Our sector rankings do not take into account today’s upside action, which was led by the Financial sector’s impressive +5.8% gains. Unfortunately for Financials, that only recovers the action of the previous six market days. Today’s action will likely be referred to as a short-covering rally for the Financial sector, but there is also evidence that some opportunistic value managers were starting to buy. Today’s rally also lifted the defensive sectors of Consumer Staples and Utilities, indicating that a major sector rotation is not taking hold just yet.

Styles: Today’s rally also helped every style grouping. Mid Cap Growth was one of the laggards today, if you can call a +2.8% gain a laggard. Small Cap Blend received the largest bounce of the day with the Russell 2000 Index jumping +3.6%, while its tracking ETF gained +3.9%.

International: The global market correction took its toll on our global rankings this past week. Every category except the European Union has now flipped over to negative intermediate trend status, and the EU is dangerously close. Today’s US stock market rally boosted the prices of all international ETFs traded in the US. We will see how much of those gains are translated back into the international markets during the overnight trading sessions.

Freddie Mac Loses His Friends

With year-end rapidly approaching, the U.S. stock market is back roughly to the level at which it began 2007. Bearish news abounded this week. The quasi-governmental mortgage bank affectionately known as Freddie Mac reported heavy losses in its loan portfolio and may need a multi-billion dollar bailout soon. We won't be surprised if taxpayers are left holding the bag; Wall Street seems to have little interest in taking on even more risk at this point, especially after a new economic forecast from the Federal Reserve suggested more economic weakness is probably ahead. Corporate news shows no hints of recovery, either.

All the bad news is causing another wave of near-panic buying of Treasury securities. This has the effect of driving down the effective yield. The U.S. 10-year bond yield dropped below 4% for the first time since 2005. Two-year notes dipped below 3% as well. The yield curve is steepening in anticipation of further interest rate cuts by the Fed. Rising crude oil prices did little to help energy or any other sector. Today even the defensive equity sectors that had been market leaders retreated amid the flight to quality. This may have something to do with holiday trading schedules, but we won't know until next week.

Our indicators continue to suggest that stocks are at a critical juncture. A great deal of technical damage has been done in the last few days, and if it is not repaired soon then further losses seem likely. On the other hand, the market benchmarks are clearly approaching oversold conditions and due for at least a short-term bounce. We should know more next week when normal trading resumes. Happy Thanksgiving.

WHIPSAW

Market Commentary: The market continues to struggle with volatile day-to-day and intra-day swings being the norm. The major question surrounding all of this uncertainty remains unanswered – will the subprime slime drag the US economy into a recession, or will global growth save the day? Weighing in on the issue today, the Fed released its first set of forecasts under its new disclosure policy. Fed officials now anticipate a soft-landing, moderate economic growth, stable inflation, and low unemployment through 2010. However, they admitted that their forecasts are surrounded by uncertainty.

The 10-year Treasury yield continues its march toward a 3% handle by closing today at 4.05%, down from last Wednesday’s intra-day peak above 4.3%. This is its lowest yield in more than two years and suggests that bond investors currently fear recession more than inflation.

Sectors: Our sector rankings are displaying a typical “weak market” picture. The classic defensive sectors of Consumer Staples, Utilities, and Health Care are at the top of our rankings and remain in positive trends, while the other sectors are exhibiting negative intermediate-term trends. The Financials continue to be knocked down on bad news. Today, the Federal Home Loan Mortgage Corp (FRE), better known as Freddie Mac, announced a $2 billion loss. It closed today at a price that was nearly 25% lower than yesterday and about 60% lower for the year. Fannie Mae, the Federal National Mortgage Association (FNM), has experienced a similar fate.

Styles: Many of the style categories are now in full-fledged corrections, and some are approaching bear-market territory. Small Cap Value is showing a -15% decline from its mid-year peak, is at a 52-week low, and has wiped out all its gains of the past 20 months. Large Cap Growth and Mid Cap Growth have also experienced pullbacks the past few weeks, but so far, they remain well above their 52-week lows and are in much better “relative” shape than their Value counterparts.

International: Global equity markets continued their retreat this past week. On a relative strength basis, the theme of the past year remains the same – Emerging Markets continue to outperform the Developed Markets of the world.

Record Year on Wall Street

As the stock market continued to sell off, news reports today estimated that the top Wall Street firms will pay out record bonuses at year-end. The five leaders - Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch (MER), Lehman Brothers (LEH) and Bear Stearns (BSC), collectively employ 186,000 workers who are expected to split bonuses of about $38 billion. This is in addition to normal salary and benefits, and works out to an average of $201,500 per person.

Of course, many employees will receive far less than average because a small number of top producers will keep most of the money. The one group that seems destined to receive nothing is shareholders, who have lost some $74 billion in the market value of their shares this year. The companies will argue that competition for top traders is fierce and they must pay for talent. It remains unclear how many shareholders will agree with this logic.

Stocks tumbled today to open the holiday-shortened week. Financial stocks were again the downside leaders, with sector benchmarks dopping to test their early November low points. One analyst estimated that Citigroup (C) will have to write down another $15 billion in subprime loan losses. The classic defensive sectors are beginning to assert clearer market leadership in our momentum rankings. Utilities, consumer staples, and health care funds are the main islands of stability right now, while the uptrends in technology, energy and materials seem to have broken down. Gold funds still dominate the top of our lists but are falling fast.

Due to the Thanksgiving holiday, our next update will come to you on Wednesday, November 21.

More Things Change

Signs of change continue to grow in markets around the globe. The exact nature of the change is still unclear. Nervousness has returned to the credit markets, with no less than General Electric (GE) posting a 4% capital loss in an "enhanced cash" fund that was supposed to remain as stable as a rock. Other companies like Bank of America (BAC) have avoided similar fates for their money market funds only by injecting large amounts of company cash to reimburse the funds for losses in mortgage derivatives. As yet, no money market funds have "broken the buck" but it may be only a matter of time.

In any case, the recovery of the financial services sector now appears to have been nothing more than an oversold bounce. Another test of the lows seems likely. Crude oil prices are backing off, to the detriment of energy and energy service sector funds. Capital appears to be flowing toward the traditionally defensive corners of the stock market: utilities, consumer staples, and health care. Financial services, consumer discretionary, and real estate are the most bearish sectors for now, but technology is looking increasingly vulnerable. Further complicating the situation is dollar weakness. From a U.S. perspective, this means better results can be found in foreign stocks, even if those stocks are actually performing no better than their U.S. counterparts. Investment maven Jim Rogers made news today with bearish comments about the dollar and re-stated his intent to be out of dollar-denominated assets in the near future. We find it hard to disagree.

Waterfall

Market Commentary: A swift and volatile downside move was the primary action in the equity markets for the better part of the past week. The high-momentum segments of the market, those that have been exhibiting most of the recent strength, were hit the hardest. The Nasdaq 100, the domestic market leader, dropped -10.9% in just four market days. On the international front, iShares MSCI Emerging Markets (EEM) shed -10.2% and iShares FTSE/Xinhua 25 (FXI) plunged -14.5% in those same four days. Whether this marks an abrupt change in market leadership or just a temporary correction for the existing leadership remains to be seen. By the same token, the strength in the Financial Select Sector SPDR (XLF) this past week does not guarantee its woes are over.

The 10-year Treasury yield closed today at 4.27%, just slightly lower than a week ago. Meanwhile, yields continue to climb in the high-yield segment, suggesting that investors believe the odds of a recession are increasing.

Sectors: The big drop in high-momentum sectors this past week caused Technology and Energy to drop in our rankings. The defensive sectors of Utilities and Consumer Staples have now risen to the top while Telecom has replaced Financials at the bottom of our rankings. The Telecom sector is currently displaying extremely divergent results on a global basis. The US Telecom sector, as indicated in our chart, is extremely weak thanks to dismal performance from Verizon (VZ) and Sprint (S). However, the international telecom sector is behaving quite well thanks to strong showings by Vodaphone Group PLC (VOD), Vimpel Communications (VIP), and Telefonica SA (TEF).

Styles: The sell-off showed little mercy as all domestic style categories suffered this past week. There was not much change in the relative rankings, but absolute strength took a hit across the board, flipping the last five style categories to negative intermediate-trend readings.

International: More air was let out of the China market this past week, allowing us to drop the frothy label. Canada also took a big hit thanks to pullbacks in both the energy markets and the Canadian dollar. Latin America takes over the top spot in our global rankings for now, but with volatility remaining quite high, our rankings could dramatically change again. The bottom of the list has not undergone much change, with Japan and the USA continuing to occupy the bottom two slots.

Momentum Shift

"Everything people were buying they're now selling, and everything they were selling they're now buying." That is how one currency trader, quoted by the Wall Street Journal, described the turnaround in global markets. It's not quite a perfect description but is close enough. A lot can change in three days - and it did.

Prior to last Thursday, the technology sector was the place to be for U.S. equity investors, while financial services and consumer discretionary stocks were in solid downtrends. They're still in solid downtrends, but they've been joined by technology, industrials, and to a lesser degree health care, materials and energy. The remaining islands of stability are utilities and consumer staples. These are traditionally defensive sectors, the kind you would expect to be strongest in a period of economic weakness. It is no surprise, then, that they are rising in relative strength just as more signs of a recession for the U.S. economy become apparent. Meanwhile global strength seems to be shifting from Asia to Europe.

Bottoms Up

Trying to pick key market turning points is tricky business. Downtrends usually end with something traders call "capitulation." You could also call it "surrender." When the last bearish investor sells his shares and heads to the sidelines, then stocks have nowhere to go but up. Did the last bear sell today? We don't know yet. There was a fairly substantial turnaround in the afternoon after a very weak morning. This suggests that many of the "weak hands" may now be out of the picture. If so, we may look back on November 8th as a day of capitulation, much like August 16th and March 14th. Unfortunately we do not yet have the benefit of hindsight to be sure.

There is a key difference in the past week's action that we are watching closely. Technology has been the strongest sector for several months now with only a few short periods of underperformance. At the same time, financials have been the weakest sector. Tech stocks, the thinking goes, have little or no exposure to subprime mortgage derivatives. This explains the relative strength of both technology sector funds and Nasdaq-based style funds, which tend to have a heavy weighting in technology and only minimal exposure to financials. In the last few days technology and financials dropped together. Financials were still weaker, but the difference shrank considerably. What does this mean? Maybe nothing, but it is a significant change.

Today's technology sell-off was sparked by news from Cisco Systems (CSCO), which said that a decline in sales to automotive and financial companies is curbing growth. So maybe the tech sector is exposed to subprime mortgage losses - but indirectly as its customers in that sector are forced to cut spending. One day and one company does not make a general trend, of course. We will watch carefully for more signs of change.

FOMC in a Bind

Market Commentary: The market’s upside move after the Fed’s interest rate cut last week was short lived. In fact, most equity markets began a short-term downtrend the very next day. As part of their announcement last week, the FOMC did their best to dampen expectations for further cuts. Perhaps that is what the market chose to focus on, or perhaps it was additional subprime related write-offs and disappointing earnings reports. Volatility remains quite high with triple digit moves in the Dow Jones Industrial Average becoming commonplace. Today was a downside day, thanks to General Motors (GM) announcing a $39 billion loss and Morgan Stanley (MS) joining the subprime write-down parade.

The 10-year Treasury yield jumped a bit after last week’s interest rate cut, but like equities, yields on Treasury securities have been in a downtrend the past week. The opposite appears to be true for high-yield bonds as investor nervousness about the domestic economy is causing prices to fall and yields to rise for this group.

Sectors: Surprisingly, not all sectors lost momentum this past week. Technology bucked the trend, especially large-cap technology stocks, by posting solid gains for the week and building on recent momentum. The Energy sector posted very strong gains for the past week, but the overall momentum for this group remained about the same due to high volatility and a steep decline the prior week. The Financial sector, the epicenter of current market weakness, had another setback this past week. Financials continue to react negatively to bad news and should be avoided at least until bad news becomes expected.

Styles: The effect of a weak US dollar can be seen in our style rankings as well as our global rankings. A weak dollar helps large multinational corporations with large overseas operations and sales. These types of companies typically fall into the Large Cap Growth segment. Smaller firms that often import many of their goods and materials and have very little in the way of exports are typically hurt by a weak US dollar.

International: Some of the air was let out the China market this past week. It is something that has been expected for quite a while, as that kind of strength cannot be sustainable for too long. There is nothing to indicate that China is headed for a massive correction at this time, but we wouldn’t be surprised if it languishes for several months. Canada has jumped into the number two spot based on a combination of a strong currency and an economy heavily weighted toward energy and natural resources.

Bad News Deluge

Investors who have been waiting for the "other shoe" to drop may feel like a giant centipede is bearing down on them. A deluge of bearish news hit the stock market Friday and today. Subprime mortgage losses are still hitting Wall Street, with Merrill Lynch (MER) and Citigroup (C) both reporting larger-than-expected writedowns - and both CEOs leaving as a result. Investors clearly do not think this will solve the problem as both stocks continued to drop, taking financial services sector funds down with them. The analyst who first reported the possibility of greater losses at Citigroup reportedly received death threats. Homebuilders, materials, energy, and luxury retailers fell today. The only sector able to show significant strength was utilities.

Concurrent with all this, the previously impregnable Chinese stock market gave up the last month's gain as Premier Wen Jiabao said his government may delay a plan to allow mainland investors to buy stocks listed in Hong Kong. It remains to be seen whether this will be a quick correction or an end to the China boom. A violent government crackdown on civil unrest in Pakistan created more geopolitical concerns about the Middle East, combined with hopeful signs in the Turkey-Kurdistan disagreement to drive oil prices up and down in rapid succession.

Amidst all this it is actually quite impressive that some sectors are still in solid uptrends when examined on a long-term or intermediate-term basis. Technology in particular has substantial upward momentum. Energy and materials have weakened somewhat, though a rally in gold may help turn around the natural resource stocks. Major support levels on the index benchmarks are holding so far. The weakness of the last few days has brought the market back to the bottom of its trading range. That makes this week a critical test; stocks need to move back up quickly or there could be a lot more downside coming.