A Silver Lining

Market Commentary: Global equity markets have been in a decline since October 2007. Most segments were quickly approaching bear market status by late January, when a rally attempt commenced. The rally lasted about two weeks and ran into trouble when major benchmarks approached the former support levels created by the lows of August and November 2007. As often happens, the former downside support levels have now become overhead resistance. Last week’s market decline took the wind out of the sails of that rally attempt by erasing a large part of those gains. Investors looking for the silver lining can take comfort in the fact that the January lows have not been breached yet. However, until the markets can overcome the resistance that stopped the rally last week, they will likely be mired in predominately-negative trends.

Ten-year Treasury yields have been trading between 3.53% and 3.81% since January 24, 2008. Further declines in yields are not expected because the value of locking in current rates for the next 10 years is not very appealing, especially if inflation fears become reality. Investors requiring a fixed income component in their portfolios should consider inflation-protected securities as a means of mitigating the long-term effect of inflation.

Sectors: The beaten-down groups, primarily the Financial and Consumer Discretionary sectors, led the late January rally attempt. The Financials did another about-face this past week, once again leading the downside action. Telecommunications, Technology, and Financials are the three weakest sectors. The January declines also took out many of the defensive sectors, such as Health Care and Utilities, which now find themselves in the middle of our rankings. The Materials sector remains relatively strong amid healthy global demand and industry consolidation.

Styles: Our current style rankings look very similar to last week and are a complete flip-flop from just a few weeks ago. Style differentiation is always less pronounced than for sectors. It can take many weeks before a sustainable shift in leadership can take hold. As such, it would be premature to make major portfolio shifts at this time.

International: Latin America, led by the strength of Brazil, is currently the only global region not exhibiting a negative intermediate trend. Canada, thanks to its vast exposure to natural resources, is hanging on to the #2 spot in our rankings. China is currently the weakest global market, but it appears to be stabilizing. As you probably recall, China was a top-performing market last year, reaching a frothy stage. Corrections after such run-ups are to be expected and even with its large pullback of the past few months, the long-term bullish trend for China is still intact.

Insurance Breakdown

It is no exaggeration to say that the financial services sector is in a bear market; many funds specializing in this area are off -30% or more from peaks in the first half of 2007. Yet the declines have not been uniform within the sector. Banks and mortgage lenders took the brunt of the losses while brokers and insurance companies fared a little better. Today may mark the beginning of a new phase as insurance giant American International Group (AIG) stock plunged almost -12%. The reasons should be familiar by now: write downs on derivatives related to the firm's fixed-income assets. Since it is highly unlikely AIG is the only insurance carrier to own such instruments, similar news from its peers will not be surprising over the next few weeks.

The loss in AIG today was offset by gains in energy stocks as crude oil jumped to a one-month high. Technology shares rallied as well. Looking past the short-term action, the bigger picture is not much changed. Yes, certain sectors are up nicely from last month's lows. Yet almost every equity sector is in an intermediate-term downtrend; some are trending down more slowly than others, but the direction is nonetheless down. The prime exceptions are gold and transportation - not much of a base upon which to build a new bull market. While the bottom is surely out there somewhere, it may take further losses to find it.

Inflation Fear

Having just recently conceded that recession is either already here or coming very soon, stock market investors are now persuading themselves that there is already light at the end of the tunnel. The Fed's interest-rate cuts, combined with economic stimulus from Washington, will ensure a soft landing and restore America's corporations to their rightful profitability. It is only a matter of time. So goes the story, at least.

We are reminded of several inconvenient facts. The light at the end of the tunnel is not necessarily benevolent; it may just be an oncoming freight train named "Inflation." Artificially low interest rates - which the Fed is doing its best to create - lead to inflationary pressure. The recent surge in precious metals supports this possibility. As for the governmental "stimulus plan," today the U.S. Senate said "Not so fast" to the agreement the Bush Administration had made with House Democrats. The plan could be bogged down for weeks at the rate it is going. Ironically, this might actually be a good thing for the economy. The federal government can't give money to anyone unless it also takes money from someone else.

It may be that the forthcoming inflation can be contained and a new stock market boom will follow. If so, it is likely to be a different kind of bull market, with a different type of leadership. The ability to rotate between sectors could become critical over the next year.

A Moot Point

Market Commentary: The equity markets staged their best gain in years last week. However, in a demonstration of just how volatile these markets are, most of those record gains were wiped out in the first two trading days this week. The US dollar lost strength last week while gaining strength in the last three days. As a result, the volatility in international markets was magnified as viewed from the eyes of a US investor.

A consensus is building that the US economy will experience a recession this year or has already entered one. Whether or not a recession becomes a reality is probably a moot point. What is important to investors is the severity and longevity of any particular recession. Real estate, financial services, and retailing are segments of the economy that are clearly in a recessionary mode already. However, the market likes to look ahead, and if the market believes that the monetary and fiscal stimulus activities that are currently underway will help these sectors going forward, then it is possible that we are at or near an intermediate-term bottom in the equity markets. If the market believes that the stimulus will not work, and that problems will continue to spread to more sectors of the economy, then perhaps there is more downside yet to come. Many technicians believe that a retest of the January lows is now underway. If true, we will be anxious to see the results of that test.

Daily volatility remains at high levels in the bond markets as well. Still, the move pales in comparison to the equity markets and the extreme late January corrections in the Treasury markets. The panic low 3.3% yield on the 10-year Treasury has not been approached again, indicating that bond investors now believe the worst may be behind us.

Sectors: Last week’s rally was led by the beaten-down sectors, leading many to believe that much of the buying activity was nothing more than short-covering. The first few days of this week have tended to favor the defensive sectors once again. It stands to reason a change in leadership is not a given at this time. The Materials sector remains on top of our rankings and is trying hard to separate itself from the pack. The Industrial sector is picking up steam, thanks to a strong showing by the transportation industry.

Styles: Our current style rankings look like a complete flip-flop from just a few weeks ago. However, this could also be an oversold bounce of those styles that have been the weakest since the October high. Compared to our sector and global rankings, the styles are still relatively clumped together and have a higher probability of the relative rankings changing again in the short-term.

International: Latin America continues to be the global leader on a relative basis. The USA has climbed in the rankings due to the magnified volatility in international markets that we mentioned above. Canada continues to exhibit above-average relative strength, and some smaller countries, such as Malaysia, are also outperforming their peers.

Homeowners Learn To Walk

The burning question for stock market investors over the last two weeks was fairly simple: is the worst over? Will we look back at January 22-23 as a panic low, or the beginning of something even worse? Unfortunately, because our crystal ball is foggy right now we cannot answer the question. We will note, however, that the rally in previously weak sectors like financials, consumer discretionary, and technology appears to be running out of steam. A period of consolidation would not be surprising given the magnitude of recent gains. To name just one example of a beaten-up sector, Fidelity Select Home Finance (FSVLX) gained +11.8% last week. For the calendar month of January the same fund was up only +1.5%, however, suggesting it has a long way to go before regaining its former glory.

Cynics of both the bullish and bearish variety tend to laugh whenever anyone says "It's different this time." On the other hand, does it really make sense to argue that today's financial markets are comparable to those of 1929, 1974, 1987, 1994, or even 2000? The times do change. History may repeat itself, but usually with a new and unexpected twist. Analysts are beginning to point out an unusual phenomenon. In the past, distressed homeowners could be counted on to do everything in their power to make their payments and avoid foreclosure. That is why mortgage rates tend to be lower than credit card rates. This time, a surprisingly large number of people appear willing to simply walk away from their homes and accept the hit to their credit ratings. If this trend persists, lenders could find themselves stuck with more foreclosed properties on their hands - and housing prices may take much longer to recover.

4Q corporate earnings are proving to be a mixed bag. With 294 of the S&P 500 companies having reported so far, earnings are off -24.5% from a year ago. The bulk of the change can be found in financials and consumer discretionary stocks. Telecom, technology, utilities and energy are still showing healthy growth. This is consistent with the recessionary scenario that is (the last two weeks excepted) driving defensive stocks up and economically sensitive sectors lower.