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.