Whiplash on Wall Street

The Fed cut interest rates by another 50 basis points yesterday, bringing the Federal Funds target rate down to 3.00%. Less than two weeks ago it was 4.25%. Observers disagree on exactly how much this move will help the economy, but it is certainly helping the banks. With lower borrowing costs and a steeper yield curve, lenders are suddenly in much better shape. This is being reflected in financial sector funds for now, but there is still a long way to go before long-term trends can be called bullish.

Over the years we have noticed a phenomemon that may seem odd to some readers. The happiest and, in some ways, the most successful investors are often those who pay little or no attention to the markets. Such people are particularly lucky right now because they are not straining their necks trying to follow the ping-pong action of the stock market. Those of us who, either by choice or for professional reasons, must watch the day-to-day action are seeing more and bigger swings in the major benchmarks. It's not all in your imagination. According to The Wall Street Journal, in the first half of 2007 the Dow Jones Industrial Average had an average daily range of about 112 points. Since July 2007, the average daily range has been almost 200 points. So far in 2008, the average daily range is 285 points.

Why the volatility? We do not have a completely satisfying explanation. All we can do is observe events and try to adjust accordingly. Obviously 2008 is not off to a great start. Practically every index benchmark, and most sector and international funds, is experiencing short-term weakness. In many cases the intermediate and long-term trends are negative as well. It would be easy to give up and hold cash, yet in doing so investors simply create a different kind of risk: the risk of being out of the market when it turns around. If sentiment indicators are to be believed, the turnaround will happen soon. For many investors, it can't be soon enough.

Today's rally was helpful but much technical damage remains to be repaired. We suspect some near-term consolidation is likely, and we do not rule out a reversal and retest of the lows.

Change of Leadership?

Market Commentary: It is always amazing that something so universally predicted can cause so much reaction when it happens. Today’s FOMC decision to cut interest rates by another 50 basis points is a case in point. The immediate reaction appeared to be bullish, but we have all been through these enough times to know that the initial reaction can reverse itself a time or two before a sustainable trend develops. With the Fed uncertainty now removed, the market is free to determine what it wants to focus on next – the bearish view associated with an economic slowdown, or the bullish view of the ensuing recovery. Meanwhile, volatility remains quite high even though it is down from the wild action of the previous week.

As expected, the panic extremes in the Treasury markets have now subsided. Last week’s historically low 3.3% 10-year Treasury yield is back up to 3.7%. A week ago, the 10-year Treasury was yielding about 0.5% less than the Fed funds rate, while today it is yielding about 0.7% more. As a result, most bond funds lost some value this week. Some of the exceptions include the high-yield and floating-rate funds. These segments were hit hard by subprime concerns but started to show signs of improvement this week. However, it is still too early to start aggressively building new positions.

Sectors: The defensive sectors remain near the top of our rankings, although there are signs that things could be changing. There was significant movement among the sectors this week. Just like every major market move has some counter-trend moves, every major sector rotation has some counter-rotation moves. In other words, we need more data to determine if this change is lasting. If it is, it could be an early signal that the correction has run its course for now. The Materials sector has taken over the top spot, and believe it or not, the Financial sector is now #3. Technology has joined Telecom at the bottom of the list.

Styles: Style rotation is evident this week also. Value has grabbed the top three spots in our style rankings, something that hasn’t happened in more than a year. In the “some things never seem to change” department, the Micro-Cap stocks still occupy the bottom rung of our style rankings.

International: There have been significant shifts in our global rankings as well. Latin America recaptured the top spot after a brief one-week slip to #2. Canada and Pacific ex-Japan made great strides to move into the next two slots. This change happened mostly at the expense of the European Union, which tumbled in our rankings. However, day-to-day global market leadership remains quite fluid. Don’t read too much into the one-week changes because they can revert back just as quickly.

Not Much Follow-Through

What a strange week this has been. Tuesday's sharp sell-off continued on Wednesday but a late-day rally brought a dramatic reversal. The Dow swung from a 326 point loss to a 298 point gain, making the daily range a remarkable 625 points on very heavy volume. Bullish analysts were quick to pronounce a bottom. Then this morning we learned that French bank Societe Generale had been victimized by a "rogue trader" who somehow managed to hide over $7 billion in stock index futures losses from his managers. Now it appears that Monday's drop in European markets may have been sparked when SocGen began unwinding these previously unknown positions.

It is troublesome to think that a major bank, indeed one of the world's largest financial institutions, just didn't notice that one of it's own staff had hidden away billions of dollars. The incident begs the question of how many other rogue traders are doing similar things at other banks. This can't be positive for the financial sector - which in fact was unable today to repeat Wednesday's snap-back rally. Today's gains in the major benchmarks were muted, at best, and not characteristic of a market that is ready to move significantly higher. This does not necessarily mean that further declines are coming. It is at least equally likely that we are entering a period of base-building, during which markets will be choppy in preparation for the next major move.

Our relative strength rankings continue to show a bias toward economically defensive sectors like health care and utilities. The gains in financials, real estate, and homebuilders over the last few days were impressive, but must still be regarded as short-term rallies from deeply oversold conditions. This week's gain has brought those sectors roughly back to where they were 3-4 weeks ago. The lack of follow-through in Wednesday's strongest sectors and generally low volume today suggests the major trends are not yet ready to change. Energy and materials bounced back as well, and it remains to be seen if they can continue to recover.

For the moment, then, the picture is cloudy. We may be on the cusp of a major trend change, but it is far too early to say this with any degree of confidence.

What a Week!

Market Commentary: The global sell-off accelerated this past week pushing all major equity benchmarks into deeply oversold territory. President Bush’s proposal for a stimulus package last Friday was met with a yawn from Wall Street. With US markets closed Monday, international markets took the reins and pushed the markets much lower. Tuesday was an around the world encore, and this time the US markets were open and could join in. Bernanke and crew sensed that something needed to be done. Before the market opened, they announced an emergency reduction of 75 basis points in the Fed Funds rate to 3.5%. The Fed action seemed to help mitigate the damage, but there were still signs of panic selling once trading began. Wednesday’s action started off looking like a repeat of Tuesday – down big at the open followed by a feeble rally attempt throughout the day. However, the rally caught a good tail wind mid-day, and the US markets staged one of their best days since November.

The big question is where do we go from here. Many benchmarks have already reached bear-market status by declining 20% or more. The S&P 500 and Dow Jones Industrial Average have both avoided that moniker for the time being, but both have fallen nearly 19% on an intra-day basis from their October highs.

Equity market panic has been evident in the bond market as the 10-year Treasury yield plunged to 3.3% this morning, before closing at 3.43%. In the past 45 years, there has only been one month, June 2003, where the yield was lower. It might actually be longer than 45 years, but our data source only goes back as far as 1962. There are few guarantees when it comes to investing, but if you buy a 10-year Treasury today and hold it for 10 years, you can pretty much guarantee that you will only get 3.4% per year, before taxes and inflation, for the next 10 years. The Fed Model, as maintained by Ned Davis Research, now shows stocks undervalued by 51%, the most undervalued level on the chart that begins in 1981.

Sectors: The defensive sectors remain on top of our relative strength rankings, but they were caught up in the selling this past week also. The Utilities sector is usually thought of as an “interest-sensitive” sector. When interest rates decline, yield seeking investors often buy utility stocks as an alternative. However, that was not the case this past week as even utility stocks sold off sharply. The downside momentum for many sectors has now reached unsustainable rates, and an oversold rally has likely begun. In the past few days, the short-term relative strength has been in favor of those sectors that have taken the worst beating this cycle – namely the Financials.

Styles: Nothing has changed on a relative basis. Growth is favored over Value and Large Cap is favored over Small Cap. On an absolute basis, all styles are suffering with many already in bear market territory. The July 2006 low for the Russell 2000 Small Cap Index failed to provide any technical support this past week, which makes the index vulnerable to another 10% decline.

International: International markets became extremely volatile this past week. The Hong Kong market underwent a 10% decline on Tuesday. Today, bankers in Hong Kong lowered interest rates by 75 basis points, matching the US rate reduction, and shares surged by 10%. Mainland China markets came under heavy selling pressure this week, pushing China to the bottom of our relative strength rankings. We will now see if today’s rally in the US markets carries over to the international markets.

Follow the Leader

For all the talk in recent years about global capital markets, the U.S. was still the biggest fish in the pond. On any given day the rest of the world's exchanges could be counted on to at least move in the same direction as the NYSE. New York was the leader, and everyone else followed. So it may be significant that this week the rest of the world, deprived of its leader due to our MLK holiday, decided to make up its own mind about which way to go. New York traders finally got a chance to say "Me, too!"

News of weakness and possible mortgage-related writedowns at large European and Chinese banks sparked a global sell-off on Monday, followed by an even more frenzied Tuesday. Americans returned from the long weekend to find the Dow futures down hundreds of points in pre-market trading. Ben Bernanke attempted to ride to the rescue with an emergency rate cut, but succeeded mainly in setting off even more worries. An ugly open followed but the benchmarks fought back to almost break-even before losing steam just before the close. Notably, the Russell 2000 Small Cap Index nicely outperformed the blue chips today.

The question now is whether this morning's near-panic selling represented a "capitulation" by bullish investors. The quick answer is we don't know yet. A lot of technical damage has been done. Even if we've seen the bottom, it isn't necessarily the case that a rally will follow anytime soon. The domestic economy does not seem to be improving, and with every passing day Wall Street's confidence that the Fed and the Administration can do anything helpful grows dimmer. On an intermediate-term basis, the economically defensive sectors remain the strongest parts of the domestic market, but they were relatively weak today. If this pattern continues then we may be seeing a broader shift in relative strength. More likely, the dominant trends will resume after a brief rally in the next few days.

Our experience is that reacting to sharp moves like today's is rarely helpful. It is far better to ride out the volatility and watch for more enduring signs of change. Market action over the next few days should be enlightening.

"The Devil's Arcade"

That's how one trader described the stock market today. It was ugly any way you look at it. By the close, the Dow had shed 306 points and the S&P 500 was off -2.9%, closing well below its 2007 bottom. The day did not start off so badly - in fact the benchmarks were up slightly in the first half-hour despite an announcement from Merrill Lynch (MER) that 4Q profits would be half of what analysts had estimated. The real fun began when the Philadelphia Federal Reserve Bank released its regional survey of manufacturing conditions at 9:00 CDT. Just about every sector turned lower at that point and the rest of the day was a steady downward slide.

The Philly Fed's report did not really tell us anything new. We learned that the economy is weak and recession is likely. Everyone was already aware of that. So why the big sell-off? We have a guess. In the last week we've noticed a number of previously bearish investors conclude that the market has bottomed out. They base this on the widespread bearish sentiment shown by various surveys. The problem is that investor sentiment can easily go from "bad" to "worse." It is safe to say that the bottom is closer now than it was yesterday. It is not safe to say that the bottom is here.

While practically every industry sector was off today, the biggest losers were basic materials and financial services. The defensive sectors we have been holding did better than most.

Because Monday is a market holiday to observe MLK Day, our next update will come to you on Tuesday, January 22.

Testing the Lows

Market Commentary: The S&P 500 index temporarily breached its August 2007 intra-day low today before turning around to close slightly above that level. The retest of those August lows is now in process, but the test is far from over. Even if the test eventually fails, a rally from this point is expected, though certainly not a sure thing. Earnings reports have been mixed, with the majority casting doubt on the upcoming year. The disappointing report from Intel (INTC) did not help. Not all is bleak though as IBM Corporation (IBM) pre-announced some upside surprises and Oracle (ORCL) found enough compelling value to announce the acquisition of BEA Systems (BEAS).

The 10-year Treasury yield hit a new 46-month low of 3.655% today before moving back up to close at +3.71%. Bond investors are pricing in an economic recession, and further easing by the Fed is being taken for granted.

Sectors: The Financial sector declined nearly 30% in about seven months. This represents a relatively large amount of destruction in a relatively short period of time. At some point a rally will begin. Given the magnitude of the decline, we would not be surprised if the rally has the appearance of a new bull market for the Financial sector. When it comes, it will likely be a tradable rally, but we would be reluctant to call it a new bull. One must keep in mind that a retracement move of 50% is still a retracement move, and the subsequent leg could very well be a down leg. The Consumer Discretionary and Telecom sectors are also in bear markets. Meanwhile, Healthcare and Utilities are posting year-to-date gains.

Styles: The style rankings have a decidedly bearish hue. The Small Cap Value and Micro-Cap categories have both achieved full bear market status with declines in excess of -20%. Mid Cap Value, Small Cap Blend, and Small Cap Growth could easily join them if the selling persists. The Russell 2000 is at its lowest point in nearly 18 months. The July 2006 low is just a couple percent below current levels and could provide some technical support. However, if it fails, it could be another 10% drop before the next support level is reached.

International: The so-called “developed” markets of the world took another hit this past week. The UK felt the sting more than others and now finds itself at the bottom of our global rankings, allowing the USA and Japan to move up a notch. Most emerging markets sold off strongly the past two days as investors assessed the impact a US economic recession could have on other parts of the globe.

Technology Turnaround

The next two weeks will be dominated by corporate news as companies announce their 4Q financial results. Naturally the performance of individual companies, even in the same sector, can vary quite a bit. It is always tempting to extrapolate the results from one company to the larger market. More often than not, this will lead to wrong conclusions. The thing to watch for is composite trends that are relatively consistent within each sector.

For example, today brought news that the venerable International Business Machines Corporation (IBM) had topped analysts expectations with 4Q sales of $28.9 billion. Previously, there had been a great deal of fear that economic weakness would cut into the sales of computer-related companies. Prior to today, technology was one of the weaker sectors so far in January. The IBM news dealt a blow to this argument and technology shares surged higher. Yet IBM is only one company, and it happens to be one which earns more than half its revenue from outside the U.S. So this news may not tell us much about the U.S. economy - or the prospects for companies that do not share IBM's international exposure. Our confidence will grow if more companies report similar recoveries.

Corporate earnings are not the only thing on the week's agenda, of course. We will also get important data on retail sales, wholesale and consumer inflation, jobless claims, housing starts, and the Index of Leading Economic Indicators. Speculation surrounding the Jan 30th Fed meeting is rampant, with a substantial number of traders expecting a 75-basis point cut. Some are looking for an interim cut even before the meeting. It is true that the Fed is signalling new flexibility; Bernanke and friends have been doing all they can to show that they "get it" and won't let the economy sink too far. Whether it is actually in the Fed's power to control the economy for more than the short-term is something not many people seem to be considering. We have our doubts.

Financials Rally

One of the more dangerous things an investor can do is try to pick a bottom. Picking the top is no easier. The sad fact is that markets always go down more than we think they can, and also go up more than we think they can. Legions of technical analysts have tried to develop indicators that identify tops and bottoms. Some of these indicators work, sometimes, but none are foolproof.

We say this because the question now before us is important: did the sharp intraday decline on Wednesday of this week market an important bottom? The benchmarks broke below the prior lows in November and then reversed near the lows set in March 2007. This morning there seemed to be little follow-through at first, then two important news items hit the wire. First, Fed chairman Ben Bernanke delivered a speech in which he all but promised additional aggressive interest rate cuts. Second, a rumor emerged that Bank of America (BAC) is in talks to acquire troubled mortgage lender Countrywide Financial (CFC). Within seconds, CFC stock had jumped 70%. A buying frenzy quickly spread through the financial sector. The economically-defensive sectors like health care and utilities suddenly lost their allure as buyers piled into financials.

Our first inclination is to suspect that a lot of today's gain was really short-covering by hedge funds that had placed bearish bets on financials. If the strength in financials persists for a few more days, we will know that something more is happening. For now, it appears that the benchmarks are heading toward a retest of their downtrend. Next week we will start to see 4Q earning reports. Positive surprises could create some further upside momentum. Negative surprises will do the opposite.

As Goes the First Week, So Goes the Year?

Market Commentary: Calendar year 2008 is off to a dismal start. The first five trading days produced returns of -5.1% for the Dow Jones Industrial Average, -5.3% for the S&P 500, and -8.0% for both the Russell 2000 and the Nasdaq Composite. International benchmarks performed slightly better but were still decidedly down. The December employment reports only tended to throw fuel on the fire as the probability of a US economic recession increased.

The bond market is also factoring in a high probability of recession and the need for further Fed action. Traders now put the odds of further rate reductions at 100% for the end-of-January FOMC meeting. The 10-year Treasury yield closed today at 3.79%, its lowest level in nearly 46 months. The high-yield bond market continues to exhibit weakness.

Sectors: The classic defensive sectors of Utilities, Health Care, and Consumer Staples are showing strong relative strength although their absolute strength is questionable. They are joined by Energy on the positive side of the momentum ledger. The weak sectors of Financials, Consumer Discretionary, and Telecom continue to get weaker. Technology led the downside action this first week of 2008, dropping -9.0%.

Styles: The various style categories we track are typically much less volatile than sectors. That wasn’t the case this past week with Small Cap Value dropping -8.6%. Even the best performing styles for the week (Mega Caps, Large Cap Blend, and Large Cap Value) all managed to shed -5.0%. The negative action had little effect on the relative rankings with Large Cap Growth still on top.

International: The international equity markets have also been under selling pressure since the start of the year. On a relative basis, they have held up better than domestic markets. As a result, the USA slid toward the bottom of our global rankings.

Challenges Ahead

The Dow managed to avoid another triple-digit sell-off today, but hardly looked like a pillar of strength. The major benchmarks are sitting on critical long-term support, and a breakdown from here would be highly bearish. On the other hand, many indicators point to short-term oversold conditions. A short-term bounce in the next few days will not be surprising. Even so, it remains difficult to build a bullish technical case for this market.

Signs of recession continue to mount. The national jobless rate was 5% in December, the highest in two years. Martin Feldstein, a Harvard economist and president of the National Bureau of Economic Research, now places the odds of recession at "more than 50%." Top economists are projecting the U.S. will show 1% growth in the 4Q, according to a survey by Bloomberg News.

Not coincidentally, interest rate futures now suggest a 70% chance the Fed will cut rates by a half-point at the next policy meeting on January 30th. That would bring overnight rates down to 3.75% but long-term rates for non-governmental debt are still stubbornly high. Hence there is little reason to expect the Fed will rescue the economy. It is out of their hands, at least in the short-term.

The brief frenzy in energy last week has dissipated somewhat, with crude oil dropping today based on economic weakness. Even so, energy sector funds still dominate the top of our intermediate-term momentum rankings, along with gold. The combined strength of these two sectors is a sign that the real driving force is weakness in the U.S. dollar.

Buying The Hard Stuff

Trading for the new year opened with commodities in the spotlight. Crude oil briefly traded up to $100 a barrel, thought we still haven't seen a triple-digit close. Gold popped up to a new record high and agricultural futures zoomed upward. The commodity frenzy is related to supply concerns but also may have something to do with activity in the bond market. Anticipation of further rate cuts by the Fed is driving the dollar down in relation to other currencies. This tends to be bullish for tangible goods like oil and gold. Indeed, energy and materials were the leading sectors by far in 2007.

At the same time, some of the latest economic statistics suggest that the U.S may avoid recession. If true, it would mean mean more demand for fuel and basic materials, hence we see rising prices for those things and falling prices for defensive sectors like health care and utilities. We could be on the cusp of an intermediate-term leadership change, but next week's data could easily lead to different conclusions.

While it may seem like the 2008 presidential campaign should be about over, in reality it is just beginning with tonight's Iowa caucuses. Within a few weeks it seems likely that we will know who the two parties will nominate. The market implications are difficult to predict. Election years tend to be bullish, but there are always exceptions. The prospect of major changes in tax policy, health care, and foreign trade regulation could certainly have a major impact on various sectors. This suggests we may be in for a volatile year.

Put a Fork in It

Market Commentary: The final week of 2007 came and went, reducing the value of equity markets in the process. The rally that began in late November did not extend past December 10 for most equities. It now looks like another test of the August lows is not out of the question.

The bond market was strong this past week with the 10-year Treasury yield closing today at 3.90%. Today’s release of the minutes from the December 11 FOMC meeting indicate that the Fed is prepared to take further action if economic conditions worsen.

Sectors: The year 2007 ended with Energy, Materials, Consumer Staples, and Utilities showing positive momentum while Financials, Consumer Discretionary, and Telecom are exhibiting negative momentum. Technology, Health Care, and Industrials are relatively flat.

Styles: Most entries in our style rankings ended the year with negative momentum. Large Cap Growth remains on top of the heap and is the only style sporting positive momentum at this time. Still, it is dangerously close to flipping to the negative side.

International: Relative strength in Latin America helped that category end the year at the top of our global rankings. Dollar weakness resurfaced the past few weeks, especially relative to the euro and the yen. That gave a year-end boost to European Union markets, but the weakness in Japanese equity markets proved too much of a burden for yen strength to overcome. The Japanese market peaked in late 1989, and the Tokyo Nikkei is still about 60% below its high of 18 years ago. Markets rotate, and one of these years, we expect to see Japan at the top of our rankings.