Coal in the Stocking for Retailers

Retailers who were betting on strong holiday sales are not happy with the way 2007 is ending. Target (TGT) warned this week that same-store sales for December may actually decline from a year ago. Other reports show growth that is sluggish at best. There is some hope that shoppers who received gift cards will redeem them in the next few days, but if so it will likely be at steeply discounted sale prices.

Other signs of economic weakness continue to add up. Today's government reports on durable goods orders and employment were disappointing, and investors seem to be losing confidence in the Federal Reserve to engineer a "soft landing" and avoid recession. We should begin to see the real impact of the housing bust as 4Q corporate earnings are reported in the first half of January.

Meanwhile, crude oil prices were already jumping even before today's news of the assassination of former Pakistani prime minister Benazir Bhutto. Instability in the Middle East is obviously nothing new. What is new is the possibility that radicals could take advantage of Pakistan's political chaos to seize control of its nuclear weapons arsenal. Much will depend on how this situation develops. Even in the best case scenarios, the fear-factor will probably keep a floor under crude oil prices - and a cap on global economic growth.

Due to the New Year's Day holiday, our next update will be on Thursday, January 3rd. By then we will know how the markets opened in 2008. It will be interesting to watch. Happy New Year!

Ebbs & Flows

Market Commentary: Equity markets around the globe rallied strongly this past week. The end-of-the-year is now just three trading days away, and all major indexes have a good chance of finishing the year in the plus column. Such a finish was far from certain many times during the year. All major indexes were in negative territory in early March after sporting healthy returns the prior week. A correction in late July and early August caused these same indexes to give up their double-digit year-to-date gains and become dangerously close to slipping into negative territory again. One more correction started to take hold in October, resulting in a test of the August lows. For now, those lows have held, and the market seems determined to end the year on a positive note.

The equity market’s gains of the past week have been the bond market’s loss. The 10-year Treasury yield closed today at 4.28% after dipping below 4.0% for a brief period last week. Much of the equity market woes of 2007 are tied to losses in the subprime credit markets. However, government issued notes and bonds were a different story. For high-quality Treasury securities, the yields dropped and prices rose every time the equity markets weakened this year. This made Treasury securities one of the best diversifying asset classes of 2007.

Sectors: Energy, Materials, and Utilities were the leading sectors for most of calendar year 2007 and are now finishing the year in that position. It was by no means a smooth ride. Energy had five pullbacks of -6% or more, Materials had two double-digit corrections including a nearly -16% mid-year decline, and the often placid Utilities sector had a mid-year correction of nearly -12%. Of course, the real problem area was the Financial sector, which experienced its own bear market by dropping more than -24% at one point. The Consumer Discretionary sector narrowly missed having its own bear market by holding its decline to just under -19%.

Styles: Mid Cap Growth turned in the best performance for 2007 thanks to a strong showing in the first half of the year. The Large Cap Growth style took over the leadership reins starting in July and was one investment segment that managed to avoid having a double-digit correction during the year. On the other end of the style spectrum are the Micro-Caps, which lagged the market for most of the year and appear destined to finish in negative territory.

International: International markets also underwent a series of declines similar to the US, although the superior strength of the international markets generally meant that their pullbacks were also of greater magnitude. Latin America is finishing at the top of our rankings for 2007 even though it underwent four separate corrections of more than 10%, one of which turned into a -22% mid-year bear market. China spent more time atop our rankings than any other global region this year and will likely finish the year with the best returns. However, China’s stellar performance was punctuated with two separate bear market intervals where it posted declines of -21% and -25%. Japan will likely end the year with a loss and at the bottom of our rankings where it stayed for most of 2007.

Recession In Sight?

The Index of Leading Economic Indicators came out today at its lowest level in more than two years, suggesting that the economy remains weak and recession is not out of the question. The housing slump continues to hurt employment and consumer spending. Credit is still very tight. Recession may not be inevitable, but we are still getting a reminder of what it looks like.

What will a recession mean to the stock market? History tells us that the markets can be weak in a strong economy and strong in a weak economy. This is because the stock market does not reflect the present; it discounts the future. Investors buy now based on what they expect will happen later. These expectations can be wrong, of course. Nevertheless, it is often the case that stocks begin rising when people conclude that the end is in sight. Moreover, "the market" is not monolithic. Some companies can perform well even in a recession, while others will not. This means that as the economy bottoms out, certain sectors will rotate into favor while others will lose their momentum. What keeps things interesting is that the cycle repeats itself a little differently each time.

Currently the economy appears to be in the early stages of recession, but a substantial number of investors still think there may be a "soft landing." Opinions change daily as more data comes in, which is why we are seeing substantial short-term volatility. This may be amplified for the rest of the month by seasonally low trading volume. The first week of January will give us a much better sense of what 2008 holds in store.

Due to the Christmas holiday, we will have only one update next week, on Thursday December 27th.

Emerging Markets Slammed!

Market Commentary: The action in the equity markets has been predominately to the downside since the FOMC meeting of December 11. On an intra-day basis, the S&P 500 has pulled back more than 5%, the MSCI EAFE iShares (EFA) more than 7%, and the MSCI Emerging Markets iShares (EEM) more than 10%. Bright spots have been hard to find as negative sentiment appears to be taking the upper hand. Investor expectations are clearly lower, leaving some potential for upside surprises.

Credit markets are still a mess. The ECB injected an unprecedented $585 billion (more than half a trillion) of cash into the banking system to help bring this crisis to an end and ensure that banks have enough cash for year-end needs. Treasury yields are back in the same neighborhood they were prior to the Fed’s interest rate reductions last week. The 10-year Treasury yield closed today at 4.07% while traversing a range of 3.99% to 4.26% this past week.

Sectors: Utilities, Energy, and Consumer Staples held up the best this past week amid the global equity market pullback. The Materials sector did not escape the selling, getting bumped out of our top spot. The Financial and Consumer Discretionary sectors were knocked down hard once again with Financials dropping nearly 11% on an intra-day basis this past week.

Styles: The style rankings have been fairly consistent for the past few months. The domestic market continues to favor Large Caps over Small Caps and Growth over Value.

International: Strength in the US dollar and weakness in the international equity markets teamed up for a one-two punch for international holdings of US based investors. This has caused a high degree of movement within our relative rankings over the past week. We will need some additional time to determine if this is just a short-term event or the beginnings of a more significant shift.

Stagflation Lives

Those old enough to remember the 1970s may remember "stagflation." It describes an economy that features the worst of both worlds: low or negative growth and rising prices. Such times are decidedly unpleasant. In a depression, your income falls but the things you need to buy get cheaper at the same time. With inflation, everything costs more but your income is probably rising, too. Stagflation doesn't have a silver lining. It's bad no matter how you look at it.

Thus it was rather shocking to hear retired Fed Chairman Alan Greenspan tell ABC News over the weekend that he now sees the "early symptoms" of stagflation. Others concur; economists at JPMorgan Chase are forecasting the slowest global growth in four years this quarter, along with the highest inflation in a decade. The ongoing credit crunch is not easing despite the best efforts of the Fed and other central banks. Rapid growth in China and other emerging markets is driving up food and energy prices. It is beginning to look like the perfect storm may be coming.

Lipstick on a Pig

That is how one analysts describes the coordinated effort by the Federal Reserve and several other central banks to drive down interest rates by injecting new liquidity into the bond market. William O'Donnell at UBS Securities said "What the program will not do is cure the cancer that got us here in the first place - the housing bust, the collapse in credit conditions, etc. We view this new program as palliative, and not a cure. Much more time is needed and much more pain is up ahead."

The way this plan emerged is puzzling. On Tuesday the Fed disappointed the markets with a quarter-point interest rate cut and the Dow promptly plunged. More important, key lending rates did not budge, showing that banks were still unwilling to extend credit. Then Wednesday morning the broader plan was announced. It would have made much more sense and saved everyone a lot of grief had they announced both at the same time. It is unclear why this was not done. Confidence in the Fed is waning, and it couldn't come at a worse time. For this reason we continue to favor defensive equity sectors such as health care, utilities and consumer staples.

International funds had a nice run in recent weeks as the dollar lost ground against other major currencies. That trend appears to have slowed.

A Market Displeased

Market Commentary: At yesterday’s widely anticipated FOMC meeting, the Fed decided to lower the fed funds target rate to 4.25% and the discount rate to 4.75%, a reduction of 25 basis points for both. The typical market reaction to a Fed interest rate change is an immediate increase in volatility with a couple of directional reversals thrown in, all within the first hour of post-announcement trading. Yesterday was different. Volatility picked up, but all the action was to the downside. The market was apparently signaling its displeasure with the magnitude of the cut. Overnight, the Fed joined forces with the European Central Bank, Bank of England, Bank of Canada, and the Swiss National Bank to inject billions of dollars (and other currencies) into the banking system. The markets applauded this move by gapping up at today’s open and recapturing the better part of yesterday’s sell-off. The euphoria quickly faded with stocks drifting lower until the final hour when they briskly sold off and then turned around to rally into the close.

Treasury yields climbed most of this past week. The 10-year Treasury yield was hovering around 4.1% prior to the Fed announcement and then plunged to finish the day below 4.0%. Today, following a path similar to the stock market, the yield surged back up to 4.18% shortly after the open and then drifted lower to close at 4.08%.

Sectors: Energy climbed back into the #4 spot in our sector rankings this week, and crude oil moved back above $90. There is a noticeable disjuncture when viewing the absolute strength graphs of the major sectors. The chart depicts a typical smooth decline in strength as we move down the list from Materials to Industrials. At that point, there is a sharp break in graphical display before the poorly performing sectors of Consumer Discretionary, Financials, and Telecom show up. It almost looks as if there are a handful of sectors missing from the chart that should be inserted between Industrials and Consumer Discretionary, but that is not the case.

Styles: Once again we have very little change in the relative rankings among the various styles even though the absolute strength improved across the board. The domestic market is clearly favoring Large Caps over Small Caps and Growth over Value.

International: Latin America led the global charge this past week and moved into our top position. The Russian market also performed quite well, helping to improve the standing of Diversified Emerging Markets. Canada is at the bottom of our list again, with the US performing only slightly better.

Pushing On A String

We come once again to Federal Reserve time. The futures markets suggest a high probability that the Fed will cut short-term rates by 25 basis points to 4.00% on Tuesday. The bigger question is what sort of statement will accompany the announcement. The Wall Street honchos want reassurance that the Fed will take aggressive action to stabilize their bonus checks, oops, we mean stabilize the economy. We have no doubt the Fed will do what Wall Street wants. Whether they will succeed in stabilizing anything is another question.

The problem is this: whatever generous loan terms the Fed offers to the banks will not necessarily inspire those same banks to be any more flexible in granting credit to businesses and consumers. Economists call this phenomenon "pushing on a string." It is an evocative image; no matter how hard you push on string, all it does is pile up around your feet. Lenders are in no hurry to take on any additional risks after being stung so badly this year. Until that attitude changes, Fed policy will have little lasting impact. Perhaps Ben Bernanke has an unexpected rabbit in his hat, but so far we see no evidence of one. Tighter credit leads ineluctably to economic slowdown.

This outlook is consistent with the recent patterns in sector relative strength. The strongest intermediate-term momentum is found in defensive stocks like utilities, consumer staples and health care. Dollar weakness is allowing materials and energy to also move up, but those sectors face heavy overhead resistance. Our best guess is their momentum will fade shortly.

Just What We Need

Investors relaxed as media reports of a government bail-out plan for subprime mortgage holders seemed to be taking shape. The idea is to freeze interest rates for homeowners whose mortgages are scheduled to balloon to higher rates that would push them into default. We are wary that any such plan will ever see the light of day, and that it will have the desired effect even if it reaches fruition.

The first problem is that the troubled mortgages have been sliced and diced into a plethora of derivative securities owned by many different parties who may have wildly different goals. The legal and practical complexities of implementing a bail-out plan cannot be overstated. Think about all those papers you signed when buying your home, then multiply it by several million and you will get the idea. Second and perhaps more important, it is far from clear that freezing mortgage rates for some borrowers will solve their problems. It may just delay the inevitable. Lenders have been selectively doing this sort of thing for a long time, and reports show that the borrowers often end up defaulting anyway in another year or two. The best solution will almost certainly be to let nature run its course. As people default, more homes go up for sale and prices fall, the economy will naturally restore the balance that was lost over the last few years. The pain this will cause for many people is sad but there really are no better options.

The stock market is less concerned about borrowers and more concerned about the losses faced by banks and other lenders. Investors seem to welcome the bail-out talk since financial stocks are up sharply the last few days. Here again, we are concerned that the optimism is misplaced. Intermediate-term momentum still favors the economically defensive sectors like utilities, consumer staples and health care.

Follow-Through Day!

Market Commentary: The market kicked-off a new rally last week and established a strong follow-through today. For widely followed equity benchmarks such as the S&P 500 and the Dow Jones Industrial Average, it appears that the lows of last week constitute a successful retest of the August lows. It should be noted however, that it has been the Nasdaq and the international markets that have been providing the leadership for much of 2007, and the November pullback did not approach their August lows.

Investors are banking on another interest rate cut from the FOMC next week. Additionally, a word we haven’t heard in a couple of years – deflation – is now popping up in economic discussions. As a result, the 10-year Treasury yield finds itself back below 4% again, closing today at 3.91%.

Sectors: This past week produced an across-the-board improvement in our sector rankings, which now show half of the major sectors in positive intermediate-term trends. Relative strength is similar to last week and is exhibiting a definite bias toward defensive sectors such as Utilities, Consumer Staples, and Health Care.

Styles: The global equity rally that kicked off a week ago improved the absolute strength of all style categories while producing little change in the relative rankings. The domestic market is clearly favoring Large Caps over Small Caps and Growth over Value.

International: China has bounced back into our top spot in the global rankings, signaling once again that it may be premature to declare the bursting of the China bubble. US-based investors with large positions in Canada are learning that currency translations work in both directions. For the first 10+ months of this year, Canadian equity investments were boosted by a 31% appreciation of the Canadian Dollar (often called the Loonie) versus the US Dollar. However, in the past four weeks, the Loonie has plunged more than 9% against the greenback, pushing Canada to the bottom of our global rankings in the process.

Home Stretch

December is here and 2007 is turning out to be a year many investors would prefer to forget. It is, of course, still possible that a Santa Claus rally will help the record books record an "average" year. Stranger things have happened. Yet the evidence suggests that whatever December brings, the longer-term picture is less than positive.

The stock market is driven by many factors but in the end they all boil down to one: corporate profits. When companies are making money - or when investors at least antipate that the will make money in the near future - you can expect to see stable or rising equity prices. When business is not growing and profitable, stocks are less valuable. This is why some recent reports are more than a little disturbing. Despite record earnings from foreign sales, per-share profits for the S&P 500 companies fell almost 25% in the 3Q. Some analysts expect the 4Q to be even worse.

Of course, profitability is not evenly dispersed. There are substantial differences between the various industry sectors and even between companies of the same sector. The bulk of this year's losses are in the financial services sector thanks to the meltdown in subprime mortgage securities. Unfortunately this happens to be a very big sector, and its problems threaten to spread into technology, retail and construction spending. Softness in the economy is also part of the reason that energy prices are in retreat. So far, oil company profits are still strong, but if the economy moves into recession even this powerful sector could lose its long-term momentum.

The safe havens continue to be the defensive sectors: utilities, consumer staples, and health care, along with selected foreign markets and Treasury bonds.