Signs of Life

The U.S. economy grew at a 3.8% annual rate in the second quarter of 2007, the government reported today. This was a substantial increase from the 0.6% rate posted in the first quarter, causing some to feel a little more optimistic about avoiding recession. Unfortunately, the report does not reflect events from July 1 to the present, a period in which the housing market's downturn accelerated. Indeed, a separate report today showed that new home sales fell 8.3% in August, and the median sales price dropped by 7.5% from a year ago. This was the steepest plunge in housing prices since 1970.

Clearly, then, the housing sector has not yet hit bottom and may not do so for a long time. So why are stocks going up? The stock market appears to have accepted facts and is in the process of adjusting itself to a different environment. Financial services and consumer discretionary stocks are the losers in this scenario, along with the homebuilders themselves. Who wins? No one, really, except for the fact that the Fed's interest rate cuts have sparked inflation fears and a flight out of the dollar and into commodities and foreign markets. Hence we see major rallies in energy, gold, and emerging markets.

The stock market has been called a giant discounting mechanism. It values companies based not on their current condition, but on a consensus outlook for their future prospects. This year's reality matters less than next year's forecast. Whatever else is going on in the world, the market consensus appears to be that aggregate corporate profits will remain generally strong. There is a great deal of variation within the benchmarks because some companies and sectors are expected to do better than others. In the big picture, however, the prognosis looks a lot brighter than it did a few weeks ago. Hence we see the benchmarks moving back up toward their recent highs. Whether they will be able to break through is the next big test. The Nasdaq 100 is already above its July peak; the Dow and S&P 500 need to follow soon.

Holding Steady

Market Commentary: Volume is starting to pick up again now that the Fed has come to the rescue. August is typically one of the lowest volume months of the year. August 2007 was an exception, an extreme exception. Monthly volume for the NYSE and Nasdaq both hit new lifetime highs. Unfortunately, the vast majority of that volume came on the downside, leaving those huge volume spikes painted red on computer terminals across the country. During the last half of August, the seasonal reduction in volume did return. Volume typically picks up within a week after Labor Day, but that was not the case this time. It wasn’t until the FOMC meeting last week that volume started to return to the market. The markets haven’t staged a significant follow-through since the Fed-inspired action of last week. However, it is encouraging that the markets haven’t really given back anything either.

The Fed action has steepened the yield curve through changes at both ends of the maturity spectrum. Short-term rates and 2-year yields have dropped, five-year rates are essentially the same as they were before the meeting, but 10-year and 30-year yields have increased. If the Fed action was meant to help consumers, the opposite has happened. If it was meant to help banks that borrow short and lend long, then they should indeed reap some benefits.

Sectors: On a relative basis, very little has changed for sectors over the past few months. The strongest in late June are still the strongest today. The weakest in June are still the weakest today. On an absolute basis, all the sectors went through significant changes. All were strong in late June, most were weak in mid-August, and most have regained their strength here in late September.

Styles: There has been some minor jockeying for position in our style rankings, but the overall theme remains the same. The market is currently favoring Growth and Large Cap while shunning Value and Small Cap.

International: The performance of the Chinese market is putting the rest of the globe to shame. However, with an intermediate-term momentum reading of 138, China is certainly extended, and perhaps frothy.

Fed Rally Fading

Last week's Fed-inspired stock market bounce appears to be slowing down. It is possible that a brief pause will refresh the forces of bullishness and allow the benchmarks to break out to new highs. It is also possible that lower short-term interest rates will turn out not to be the economic panacea some expected. The Fed has administered medication with significant side effects that may or may not be tolerable. Long-term interest rates, for example, surged as it became clear that Ben Bernanke is not quite the inflation hawk he used to be. For example, stressed homeowners who thought they could refinance their adjustable-rate mortgage to a 30-year fixed-rate loan are finding that option is no longer as attractive, if it is available at all.

In the economic big picture, lower interest rates mean a bigger money supply. More dollars in circulation means that each dollar is worth a little less than it used to be, as compared to other currencies or to tangible goods. This phenomenon is called "inflation" and the markets seem to be anticipating more of it in the near future. Gold and crude oil shot up in the last week for that very reason. Gold is perhaps a better proxy for the monetary aspects of inflation, but energy may have more upside. Consumers around the globe who have little use for gold coins and jewelry have little choice about buying petroleum-based products. Rising prices the last few years have shown little impact on overall demand. With Treasury futures trading indicating that more rate cuts are likely, the downtrend in the dollar and concomitant uptrend in commodities seems likely to be with us for some time.

Shock & Awe?

Market Commentary: The most highly anticipated FOMC meeting in recent memory is now in the history books. Choosing to sacrifice the threat of inflation over market liquidity concerns, the Fed lowered both the Federal Funds Rate and Discount Rate by 50bps. This appeared to be what the market was looking for, and perhaps even more. Equity markets responded positively around the globe.

Although the Fed has lowered interest rates, the yield on the 10-year Treasury has climbed significantly the past eight trading days from 4.32% to more than 4.52%. The new level is slightly higher than the 4.49% level that prevailed prior to yesterday’s announcement. So far, the interest rate reduction has not filtered through to intermediate and long-term government securities, but don’t tell that to equity investors.

Sectors: All sectors received a boost this week with the most depressed (Financials and Consumer Discretionary) receiving some of the biggest bounces. The change in the environment has helped these groups, but the rate cut is an acknowledgment that these sectors are in trouble. Lower interest rates may also provide additional weakness for the US dollar and carries inflationary concerns. These factors help improve the outlook for the Materials sector, which has jumped back into the number two slot in our sector rankings.

Styles: The various investment styles are virtually unchanged from a relative ranking this week, but they all improved their absolute standing considerably. Mega Cap and Large Cap Growth remain the favorites while Micro Caps and Small Cap Value trail the field.

International: What’s good for the US is great for the world, or so it seems. Most of the globe got a good pop this week. The notable exception is Japan, which is mired in its own problems.

Waiting for Tuesday

Each Monday the Wall Street Journal provides a little day-by-day list of important events for the coming week: earnings announcements, economic data releases, etc. It is a nice feature that helps traders know what to expect. This week's version includes the usual minutiae, but might just as well have a single entry: "Tuesday, 2:15 Eastern Time, FOMC announcement."

FOMC stands for Federal Open Market Committee, the group which decides on the Federal Reserve's interest rate policy. Wall Street is certain this meeting will end with a rate cut and debates only whether it will be one-quarter of a percentage point or half a percentage point. Chairman Ben Bernanke and his colleagues are well aware that the market will not appreciate any surprises. Since they have not tried to signal any disagreement with the prevailing expectations, a rate cut of some degree seems very likely. More important will be the accompanying statement that may provide clues to future Fed policy.

Reaction to whatever the Fed does is difficult to predict. Indeed, with such widespread consensus it seems almost certain that the impact of a rate cut is already baked into asset values. It is hard to imagine anything the Fed could say or do that would create a bullish reaction for stocks - but Bernanke may have tricks up his sleeve we don't yet know about. The recent rise in commodity prices, especially oil and gold, and a concurrent decline in the dollar and yen are almost certainly related to the impending Fed action.

Across the Atlantic, a bank in the UK called Northern Rock is experiencing an old-fashioned bank run. The Bank of England bailed out Northern Rock last week, but customers are are still lining up (or "queuing" as the British like to say) to withdraw their deposits - to the tune of about $4 billion so far. This is minor in the grand scheme of things, but a troubling reminder of how some institutions may be close to the edge.

As a measure of how fixated the markets are on tomorrow's decision, consider that today's NYSE volume was the lowest for a full trading day so far this year. Clearly investors are in wait-and-see mode, and wisely so. Stay tuned for an interesting week.

Holding Pattern

A three day rally brought the U.S. stock market back near the top of its short-term trading range. An interesting chart pattern has developed in the S&P 500 over the last four weeks. Intraday high and low points show, since August 16, a series of lower highs and higher lows. In other words, stocks are trading within an increasingly narrow channel. One trendline or the other will have to break soon.

We suspect this quandary will be resolved through the catalyst of next Tuesday's Federal Open Market Committee meeting. Trading in the futures markets indicates a high probablity of a 50 basis point cut in the Federal Funds rate, from the current 5.25% to 4.75%. Anything less will be considered a disappointment. Fed Chairman Ben Barnanke and the other committee members haven't dropped very many hints, which suggests the market is probably guessing right. Pundits are now turning their attention to the impact a rate cut will have on the U.S. dollar. It won't be good, but the question is whether the effect is already reflected in exchange rates.

A weaker dollar is typically good news for commodity prices. This may be why crude oil rose to a new record high on Wednesday, briefly trading above $80. Energy-related equities, while picking up some momentum, still remain well below their July peaks. Gold has also popped higher, moving above $700 and sparking a rally in gold stocks. Fidelity Select Gold (FSAGX), for instance, jumped from # 25 in our momentum ratings this time last week to # 2 in today's table. We've seen it move just as quickly in the other direction, though, so we are not ready to buy gold funds just yet.

FOMC and Triple Witching Next Week!!

Market Commentary: The market recovery lost some steam this past week, but it hasn’t given up. Even though the rally stalled as the 50% retracement levels were reached, it would be premature to say that the rally has failed. The day-to-day action appears to be news driven and remains highly volatile. Equity traders are putting a large amount of emphasis on the upcoming FOMC meeting, and volume is expected to be light leading up to that event.

During times of commercial paper liquidity problems, the Fed has historically used the Discount Rate as the intervention mechanism. Greenspan bucked tradition by ignoring the Discount Rate during his 18 years at the helm. Bernanke has reinstated the use of the Discount Window in an attempt to separate the dual roles of the Fed: maintaining financial stability and controlling inflation. In the meantime, the bond market appeared to shrug this off, and futures traders are predicting a 74% chance of a 50bps cut to the Fed Funds rate next week. The September 18 FOMC meeting might be a meeting to remember. The Fed is receiving pressure to cut the Fed Funds rate in an effort to help the liquidity problems brought on by the subprime slime. Bernanke has made it known that he believes the Discount Rate is the appropriate mechanism for this particular concern. His resolve will be put to the test next week. He can hold his ground and leave rates unchanged, or he could attempt to appease the masses by cutting the Fed Funds rate. He could also do a little of both: cut the Fed Funds Rate but claim that heading off a recession is now a higher priority than keeping inflation under control, instead of saying that it is to address credit liquidity concerns. Meanwhile, the 10-year Treasury yield dropped as low as +4.30% on Monday (down from 5.3% in June) before moving back up to +4.41 today.

Sectors: We have a wide divergence in sector strength at the present time. There are two strong sectors, two weak sectors, and the rest are in the neutral range. Energy and Technology are the two strong sectors. Oil prices are again at new highs, and the Technology sector has successfully separated itself from the credit crunch. The weak sectors are Financials and Consumer Discretionary, a dubious honor they have held for quite a while. Real estate and the mortgage lending business are at the epicenter of the credit problems, and they are both part of the Financial Sector.

Styles: History does repeat itself, but sometimes the names are changed to protect the guilty. In 1999 it was widely believed that Large Cap Growth was all anyone needed. At that time, Large Cap Growth was the best performing style for the most recent 5-years and almost every other time-period you could imagine. Small Cap Value was at the other end of the spectrum. Last year we found those roles reversed. Investors were chanting the Small Cap Value mantra, as it was the new style king for 5-year performance (along with almost every other time-period you could imagine) while Large Cap Growth was at the other end of the spectrum. Styles rotate. Small Cap Value is now weak and getting weaker. It would not surprise us to see Small Cap Value at the bottom of the 5-year performance charts five years from now. We don’t know who will be on top, but the odds are in favor of Growth being part of its name.

International: Same song, different verse. China, and the rest of Asia excluding Japan, continue to provide global leadership. The “developed” markets of Japan, the USA, and the European Union are lagging.

Losing Jobs

Friday's weak jobs data, which we said in our last update could be pivotal, was unexpectedly weak. Economists had forecasted nonfarm payrolls would grow by 92,000 in August. The report revealed that the number of jobs actually fell by 4,000 instead. This was the first decline in jobs since August 2003. Moreover, job growth for July and June was revised downward.

Prior to Friday morning, the stock market was in its usual bad-news-is-good-news mode. If the economy is weak, the thinking goes, the Fed is more likely to cut interest rates, which is bullish for stocks. Something seems to have changed in market psychology in the last few days. Forecasts of a recession are no longer being greeted as welcome tools in the quest for lower interest rates. Bad news is now seen as simply bad news.

However you want to interpret it, the jobs data took wind from the sails of a stock market that had been trying to pick up momentum. In hindsight, it appears more likely to have reached the top of a trading range and is now exploring for a bottom. Today brought a small gain for the Dow and modest losses in broader benchmarks like the S&P 500 and Nasdaq Composite. Health care, utilities and consumer staples - the classic defensive sectors - were positive for the day while real estate, materials and industrials fell. On an intermediate-term basis, energy and technology remain the strongest sectors.

Dueling Data Points

The stock market seems to be back in data-dependency mode, results on any given day being based largely on whatever new economic and corporate data is hitting the newswires. Today was a good example. The day opened with much attention being paid to retail sales. The International Council of Shopping Centers, based on results from 47 retailers, said that August sales rose 2.9%, significantly ahead of projections. Wal-Mart (WMT), Target (TGT) and other chain stores also reported brisk back-to-school sales for the month. This suggests that consumer spending may remain strong despite the real estate downturn. On the other hand, the Mortgage Bankers Association said today that foreclosures and delinquencies are at record highs. Almost 15% of all subprime mortgages are late making payments. It's hard to see how that is good news for anyone.

Meanwhile, various Federal Reserve officials presented various opinions about the economy today, leaving observers no more enlightened than before. The consensus of today's speeches seems to be that the Fed may need a little more convincing in order to deliver a rate cut at its next meeting; none seemed to think that the housing slowdown has yet spilled into the broader economy. A flight-to-quality in the bond market remains in effect, with 10-year Treasury yields dropping fast and widening spreads with corporate bonds both in the U.S. and Europe.

Gold moved above $700 today for the first time since May, while crude oil traded above $77 before pulling back. With the Fed and other central banks acting to increase market liquidity, money-supply figures seem likely to increase. In that scenario commodity prices tend to rise. Other supply and demand factors are still relevant, of course, but all other things being equal monetary expansion is bullish for commodities. This is another factor arguing against an interest-rate cut.

Tomorrow brings the August unemployment and payroll data. This is always a critical report, and for seasonal reasons August tends to be weak. The consensus among economists is that nonfarm payrolls grew by just 92,000 in August. A lower number might be short-term bullish if it gives the Fed another reason to cut rates. With another seven market days to go before the Fed meets on September 18th, however, this number may be long forgotten before it matters.

50% Retracement

Market Commentary: Roughly half of the recent correction has now been recovered. This is called a 50% retracement and is considered typical action in financial markets. The recovery attempt stalled, or ran into resistance, late yesterday and today with many broad domestic market indexes trying to retake their 50-day moving averages. This is also considered typical action for financial markets. Volume has been lackluster during the two-week recovery, which tends to reinforce the stalling action. Volume is expected to start picking up soon as the seasonal slow period is now behind us. During the month of August, volume was a significant factor during the downswing and was noticeably light on the upswing. Now we will see what September brings.

The bond market is still mired in the process of sorting out the quality issue. There are still large pools of debt instruments labeled “unknown” with pricing that reflects that uncertainty. At the recent height of the liquidity crisis, it appeared that the only distinction being made was government or non-government. Now some level of order is being restored to some segments of the bond market. As a result, prices are drifting upward on lower quality bonds that can be separated from subprime slime. A Fed rate cut is being taken for granted later this month. This coupled with today’s release of the beige book pushed the 10-year Treasury yield down to +4.473% today, a new low for 2007.

Sectors: A 50% retracement is also common among sectors. However, we typically see a wider divergence of results here. Technology, Energy, Industrials, and Telecom are currently exhibiting a 50% or better retracement and are performing above average. The retracements for Financial, Consumer Discretionary, Health Care, and Utilities have fallen far short of the 50% mark, indicating significant weakness. These results are also reflected in our relative sector rankings.

Styles: The style segments have also had two weeks of recovery with non-uniform results. As indicated by our relative style ranking chart, Mega Caps and all forms of Growth have achieved a 50% retracement level, while the Micro Caps and Value have failed to do so.

International: The 50% retracement phenomenon is not limited to domestic markets. Most global markets have also traced a similar pattern the past two weeks. The most notable exceptions are Japan, which has fallen far short of the 50% level, and China, which raced to a new high more than a week ago.

Bull and Bear Stand-Off

For a time today, it seemed that investors had collectively decided the market waters were once again safe and a major upside rally would develop. Such hopes faded into the close, though the day still ended with solid gains in most benchmarks and sectors. Some technical indicators are turning more positive. The S&P 500 and Dow Jones Industrial Average both closed just above their 50-day moving averages and the Russell 2000 is not far behind. We will have to wait and see whether this level becomes a barrier to further progress.

A few points of concern remain. The recovery of the last two weeks has yet to attract trading volume comparable to the preceding declines. Economic indicators continue to point toward a significant slowdown at best, and possibly a recession. The housing sector is still in serious trouble. Most important, it is an open question how the Federal Reserve intends to proceed in adjusting monetary policy. Many people are assuming that a Federal Funds rate cut is all but guaranteed at the next Fed meeting on September 18th, if not before. If that assumption proves wrong, or even if it proves right, the second half of September is likely to bring further volatility. A re-test of the August lows would actually be a positive event if it is successful, but we suspect few people will think that way if it happens.

Energy stocks surged higher today, though we are not quite sure why. Economic weakness would seem to be bearish for oil prices, but the market appears to have reached a different conclusion, at least for today. Utilities, REITs, and technology all picked up some positive momentum day. A slightly longer perspective reveals that energy and technology are, by a significant margin, the strongest sectors right now. Financials are still struggling to recover lost ground.

The overall picture is of a narrow rally on average volume. Bull markets are said to climb a wall of worry, of course, and all the problems we have mentioned can be overcome. The question is how long it will take.

The End of Summer

With the forthcoming Labor Day weekend, a rough summer comes to an end for the U.S. stock market. It started out pleasantly enough, with the benchmarks moving higher into mid-July and the Dow and S&P 500 touching new all-time peaks. Yet underneath the surface the subprime mortgage problems were building, and only a month later traders were in near-panic mode as the bond market seized up in a massive liquidity crunch. The benchmarks are now off their lows, but are nowhere near recovering back into bull-market territory. Even long-term trend indicators are on the cusp of turning bearish. The big picture is not encouraging as the vacation season winds down.

Volatility over the last few days has been extraordinarily high. Volume has generally been below average, but the trading that does occur is happening in a herd-like pattern. Lacking conviction, traders are simply following the crowd in whichever direction has the least short-term resistance. This quandary may not resolve itself until the next regular Federal Reserve policy meeting on September 18th. Everyone seems to think a rate cut is just what the doctor ordered and a sharp rally will follow. We won't be surprised to see a big move sparked by whatever the Fed does, but the direction of any such move remains far from certain. If the Fed's action is perceived as weak, even a rate cut could generate another sell-off.

Sector action continues to be choppy with quick rotation in leadership. Energy popped back up in our rankings over the last few days but most energy sector funds are still in intermediate-term downtrends. There are pockets of strength in health care, technology and telecom, while financials, retailers, utilities and homebuilders all remain very weak. In the style categories, a major shift from value to growth is developing, particularly in small caps. This trend may offer new opportunities soon. China-focused international funds continue to dominate the relative strength race, but at the cost of huge daily volatility.

Our next update will be delayed a day due to the Labor day holiday, and will come to you on Tuesday, September 4th.

V O L A T I L I T Y

Market Commentary: We’ve now had five weeks of high-volatility markets with no end in sight. That is not to say that the markets will never again have a period of low volatility, in fact, just the opposite is true. The market has entered a period of high volatility, but there will be additional low volatility periods in the future. Like every other aspect of the market, volatility changes. There are bull markets and bear markets. There are times when growth is in favor and times when value is in favor. There are expanding P/E markets and compressing P/E markets. Yes, there are periods of high volatility and periods of low volatility. The stock market experienced a reversal to the upside on August 16, bringing at least a temporary halt to the decline that began in mid-July. Many technical analysts are now calling for a “retest” of the lows, and if you read between the lines, these analysts almost universally assume that any retest will be successful. Of course, that is not always the case. History is littered with examples of retests that failed, commonly called bear markets. For now, the intermediate trend is down, although that has not yet translated into a long-term downward trend.

The historically narrow credit spread of early June is now a thing of the past. In the process of correcting that narrowness, many bond market participants will agree when we say that things probably went too far and too fast the other direction. The Subprime Slime first pushed the yield on lower quality bonds higher. Then the market seized up and few buyers were willing to step forward, leaving many bond yields “unknown” due to lack of transactions. Meanwhile, the other side of the credit spread was also widening as demand for T-Bills and other government-backed securities caused short-term rates to drop to only 2.4% on August 20. Once again we had credit-spreads out of whack. Volatility is not just a stock market phenomena; the bond market has its share too.

Sectors: Energy, Technology, and Consumer Staples occupy the top spots on our sector relative strength rankings. Their absolute intermediate-term trends can be considered flat at best (low negative absolute readings), but they are the best sectors on a relative basis. The Financial and Consumer Discretionary sectors remain the worst from both an absolute and relative basis.

Styles: It has not been a smooth transition, but the regime shift from Value to Growth seems to be taking hold. Growth was the undisputed king of the late 1990s, and Value has been in charge for most of this decade. Each of the past two cycles lasted about seven years, although there is no guarantee that the pattern will repeat.

International: Our global rankings look as though they contain an error. Our sector rankings are all in the red (negative), our style rankings are all in the red, and our global rankings are all in the red with just one exception – and what a huge exception it is. China is registering enormous upside momentum. Some China funds experienced upside surges of 25% to 30% in just seven market days from August 16 through August 27. Intraday-trading numbers exhibited even larger moves. Granted, they have retreated the past couple of days, and perhaps their decline into the August 16 low was overdone, but the intermediate trend is definitely positive. Volatile, but positive.

Crunch Time

The stock market started a new week on the downside for most sectors and industry groups. Last week's rally brought most benchmarks back up to areas where technical resistance was expected, so the weakness today was not a great surprise. What everyone wants to know, of course, is whether the next big move will be up or down. A period of sideways consolidation is a third possibility, and in our view is more likely than a near-term breakout in either direction.

Bullish analysts, perhaps anticipating further volatility, are now arguing that a retest of the August lows would be helpful in providing the foundation for a new uptrend. This is certainly true, if we assume a retest would be successful. The opposite is also true: a failure to breakout above the July peaks would signal that equities are running out of upside potential. Until the S&P 500 can break decisively above 1560 or below 1375, the next long-term trend remains anyone's guess.

Sector leadership is still rotating quickly. Energy and materials bounced back over the last week, as did technology. These recoveries took place with relatively low trading volume, which suggests they may be less significant than price levels make them appear. Financial services, consumer discretionary, and real estate stocks remain relatively weak. Overseas markets, Asia in particular, staged a sharp rally today. Chinese stock benchmarks are hitting new highs, which is more than you can say for the more-developed markets. Today the SPDR S&P China ETF (GXC) jumped +7.5%.

The news calendar is fairly quiet this week. Ben Bernanke speaks at the annual Jackson Hole economic event on Friday and will be closely watched for hints of future interest rate actions.

Relative Calm

This week the U.S. stock market returned to something resembling normalcy, but it may not last long. All those bad mortgages are still bad. Lay-off announcements in the financial sector are becoming a daily event, and the Bernanke Fed is not yet instilling confidence in its crisis-management abilities. Traders remain reluctant to carry big positions overnight.

After a steep rally from last Thursday's low point, the major benchmarks may have exhausted their short-term momentum. Today the Dow, S&P 500, Nasdaq and Russell 2000 all fell back from early gains to close with small losses. Sector action is still quite choppy. Financials surged higher in the last week on hopes of an interest-rate cut, but basic materials were even more impressive. Today, however, both these sectors were easily overshadowed by energy and technology.

The current market environment is especially challenging for one overwhelming reason: no one knows if, how or when the Federal Reserve may intervene. Of course there are many reasons to be bearish right now. Yet anyone who takes a short position, especially with leverage, could wake up to a rude surprise if the Fed announces a rate cut early one morning. Conversely, if the Fed is unsuccessful in stabilizing the credit markets there is a lot more potential downside ahead. This makes it hard to justify additional equity exposure. So by default many investors are raising cash positions. Not just any cash equivalent will do, however; the market for commercial paper is shrinking quickly. Investors demand the safety of treasury bills, where yields are still substantially lower than they were two weeks ago.

Most investors are currently of a mind to avoid risk. There is more than one kind of risk. There is the risk of being in a market that is heading down, yet there is also the risk of not being in a market when it goes up. The best strategy is to balance these two types of risk, which is why our model portfolios currently hold a mixture of cash and equity funds.

Follow the Money

The big news today is the purchase by Bank of America (BAC) of $2 billion in preferred stock in the beleaguered Countrywide Financial (CFC). Deals like this are not made overnight, which leads us to think it has probably been in the works for at least a couple of weeks.

Now it so happens that other unusual things have taken place in the markets during this time - some publicly known, others not. Follow the sequence of events and an interesting conclusion emerges.

8/15 - Merrill Lynch analyst says CFC is in danger of bankruptcy.
8/16 - Countrywide taps all its available credit lines, total $11.5 billion.
8/16 - Fitch and Moody's cut Countrywide credit ratings.
8/17 - Bank of America Securities analysts (who once worked at Countrywide) upgrades CFC.
8/17 - The Federal Reserve cuts the Discount Rate and eases collateral requirements.
8/17 - Morgan Stanley downgrades CFC.
8/20 - Countrywide begins staff layoffs.
8/20 - KBW downgrades CFC.
8/21 - Rumors abound that Warren Buffet is looking at a Countrywide acquisition.
8/22 - Four mega-banks borrow $500 million each from the Fed's discount window.
8/22 - One of the four, JP Morgan (JPM), upgrades CFC.
8/22 - Another of the four, Bank of America (BAC), buys $2 billion in preferred stock from CFC.

A number of curious things are going on here. First, while CFC's very survival was in doubt the BAC analyst still found reason to upgrade it.

Second, the four large banks borrowed from the Fed's Discount Window at a rate of 5.75%, even though they are perfectly capable of financing their normal cash needs at the 5.25% Fed Funds rate. Why pay a premium? It was explained that they wished to show confidence in the Fed and demonstrate that smaller banks need not fear that use of the Discount Window would be perceived as a sign of weakness.

This explanation does not pass the laugh test. These banks are publicly traded companies. They owe their shareholders a duty to obtain the best possible financing terms. Paying an extra 50 basis points when they don't need to, and then announcing it publicly, is financial malpractice and an invitation for shareholder lawsuits. The executives know this so they must have had other reasons.

This brings us to the third curiosity: soon after the banks borrow a total of $2 billion from the Fed (remember that number, by the way; you will soon see it again), an analyst for JP Morgan upgraded CFC. Two and only two analysts on the Street upgraded CFC in the last week. Both happen to be attached to banks that borrowed from the Fed on unusual terms.

Fourth and finally, Bank of America buys $2 billion in CFC preferred stock. Wall Street breathes a sign of relief that the crisis has passed. No one seems to notice that CFC's windfall happens to be the exact same amount of money that the Fed just loaned to a consortium of megabanks.

Conclusion: the Fed has bailed out Countrywide, using BAC and the other three megabanks as a conduit. The other $1.5 billion will find its way, via circuitous routes, from the other three banks into the BAC vaults. BAC is taking no risk in this deal because they are playing with the Fed's money.

Even before the Fed acted last week, the wheels were already in motion for this deal to come together. Either that, or this is all a series of really remarkable coincidences.

If in fact the Fed is trying to bail out Countrywide, there's a good chance it will take more than $2 billion. We may see more such exotic financing in the near future, or possibly they are also acting in other ways that are not yet apparent. In any case, having tried to do this the Fed cannot afford to fail. It would be a fatal blow to Bernanke's credibility. The stakes are huge.

Relief Rally

Market Commentary: The four-week selling spree accelerated last week, hitting its nadir mid-day on Thursday. Thursday’s dramatic turn-around seems to have put a short-term bottom in place for now, boosted by the Fed’s decision to cut the discount rate by 50 basis points on Friday. Markets have been staging a relief rally – relieved that the Fed is paying attention. Perhaps we may be able to call it something stronger than a relief rally in the near future, but for now, that is all that it is.

While the Fed action was well received by the equity markets, the credit markets (which the action was “supposed” to address) remain in a quagmire. There are still few buyers for non-government debt instruments, and on Monday, the demand for short-term Treasuries was so great the yield dropped below 2.5%. It has now returned to around 3.5%, the same place it was last Thursday.

Sectors: All sectors remain in intermediate-term downtrends while trying desperately to rebound from last week’s turmoil. In what is considered typical action, the sectors that were beaten down the most have bounced the highest, so far. Needless to say, the Financial sector has been at the forefront of this action. The relative volatility in the Financial sector has reached historic levels, with prices jumping more than 10% from Thursday’s mid-day low to Friday’s opening high. Without any follow through on this brief surge, our outlook remains negative on Financials. The Materials sector also sold-off sharply last week and staged a rally of nearly 10% to coincide with the move in the Financial sector. The major difference is that Materials has now surpassed that Friday morning level, providing it with better odds for a successful recovery, although that is not a given at this juncture.

Styles: High levels of volatility have also been the norm among the various styles lately, although nothing quite as extreme as we have seen in the sectors. Growth still has the edge over Value for now, but that could change in a heartbeat.

International: Correlation increases during market declines, and that was clearly evident this past week. Global markets sold-off sharply in the face of what is viewed mostly as a U.S. problem, indicating that global markets are linked more than ever. Emerging equity markets underwent the steepest declines, especially Latin America. Believe it or not, our domestic markets have actually held up the best, vaulting them to near the top of our global rankings over the past few weeks.

Rush To Safety

As you no doubt heard, last Friday morning the Federal Reserve reduced its Discount Rate and took some other measures to encourage the credit markets. The Discount Rate is not near as important as the Federal Funds rate, which was left unchanged. It was, in our view, a largely symbolic act designed to send a message that the Fed is not asleep at the wheel. If so, it had the desired effect - for about a half-hour. That was how long it took Friday's opening rally to top out.

Today brought another surprise. The 3-month Treasury Bill yield is a widely used benchmark for short-term loans, and it also serves as a kind of proxy for cash-equivalent assets. This time last week, it stood at 4.7%. Today the same T-Bills traded for a yield as low as 2.5%. This is an unprecedented drop, far exceeding what happened even in previous market panics such as October 1987. A fall in the T-Bill rate means that investors are willing to pay almost any price for safety. Please note, most of this decline happened today, after the Fed supposedly rescued the markets. Clearly some people are not yet convinced.

We were actually quite surprised when the Fed acted on Friday; our feeling was that Bernanke would let Wall Street fend for itself rather than risk inflation and possibly damage his own credibility. Now it appears that the main thing the rate cut accomplished was to demonstrate that the Fed is just as clueless as everyone else. The policy statement from the last Fed meeting on August 7 is now meaningless, and no one knows what kind of policy will come out of the next meeting on September 18. This creates a situation of enormous uncertainty. As a result, markets will likely remain very volatile for the new few weeks.

Sector action remains choppy. Financials, consumer discretionary, materials and real estate remain the weakest sectors, but other than T-Bills nothing is particularly strong right now.

August Lows Taken Out to the Woodshed

Market Commentary: The stock market sell-off continues with little end in sight. Today the Dow and S&P 500 both broke below their August lows. Long-term trend indicators are beginning to turn decisively bearish, which may lead to even more selling pressure in the near future. Wall Street is increasingly shrill in its attempts to jawbone the Fed into a rate cut. Ben Bernanke does not seem inclined to accommodate; the much-heralded injections of liquidity in the last few days were really quite small. The Fed is still focused on getting inflation back down to its target rate of 2%. If that means a few more hedge funds have to blow up, we think Bernanke is prepared to let them do so.

Treasury bonds are quickly becoming the asset class of choice for legions of former equity investors. Anyone who needs liquidity right now has little choice but to get it by selling stocks. With no one willing to take on any kind of credit risk, the non-government bond markets have largely ground to a halt. The great fear now is that the much-publicized subprime problems are only the tip of the iceberg. The decision by a Chicago cash-management firm called Sentinel Management to suspend redemptions for its investors is causing open speculation that one or more money-market funds may “break the buck..” So far we see no hard evidence of such a thing, but it can’t be ruled out. Whatever the underlying fundamentals may be, financial markets are in a panic mode right now. People are doing irrational things, which means anything can happen. Cash is the king for now.

Sectors: Those sectors that were still holding slightly positive in our momentum ratings (Technology, Consumer Staples, Energy) turned negative over the last week but are still stronger than anything else. Financials and Consumer Discretionary, and to a lesser degree Materials, deteriorated further and maintained their rankings at the bottom of the list. Sector action continues to grow more and more characteristic of a defensive, almost recessionary equity market. If this trend continues, we would look for Technology to lose some of its strength while Health Care gains ground. Financials are now to the point that a recovery may take months or even years. Due to its large capitalization, this sector will act as an anchor holding back the cap-weighted market benchmarks for some time to come. The good news is that we will likely have more opportunity to add value through sector rotation in the coming months.

Styles: The picture grew increasingly bearish this week as Mega-Caps gave up their top ranking to Small Growth, which itself lost momentum in absolute terms. The blue chips had been the last refuge for equity investors; the fact that they are now breaking down suggests we may be getting close to a capitulation low. It does not necessarily follow that a recovery will quickly follow, however. At the other end of the scale, Micro-Caps slowed their decline a bit but remain in a firm downtrend.

International: Global markets turned further negative, with all except China now showing negative momentum. Even China is decelerating quickly and will likely enter its own downtrend soon. The good news is that the U.S. improved its relative position against other markets over the last week. The bad news is it did this only because foreign markets, notably Europe, Latin America, and Japan, were losing ground even faster than the U.S. The liquidity crunch is clearly global in scope, and we are learning that European institutions were apparently heavy buyers of U.S. subprime debt. U.S. investors looking for a safe haven are not finding it overseas.

Looking For Help

The major stock market benchmarks are little changed since last Thursday's big drop. This may have something to do with the Federal Reserve's decision to provide extra liquidity in the bond market. The European Central Bank made a similar move the day before. The amounts involved are not huge in the grand scheme of things. Yet such actions have symbolic value in reminding traders that the central banks aren't asleep at the wheel.

Pundits in the media continue to snipe at the Fed for not cutting rates at last week's policy meeting, and many are now calling for Bernanke to take the unusual step of announcing a rate cut before the next regular meeting, scheduled for Sept. 18th. We suspect this is wishful thinking. First, Bernanke does not seem to be terribly concerned about pleasing the media, or Wall Street for that matter. He has the bigger picture in mind. Second, the Fed's job is to maintain a balance between inflation and recession. Years of strong economic activity and historically high energy prices give Bernanke little room to maneuver on the inflation side of the ledger. If he has to choose, we suspect it will be in favor of slowing down the economy. That argues against lower interest rates. At this stage a rate cut would simply trade short-term relief for more long-term pain.

A look at our Fidelity Select rankings today is interesting. First, notice how the various financial services sector funds are clustered at the bottom of the list. Banks, brokers and mortgage lenders have been decimated in the last few weeks. Fortunately we haven't had any exposure to that group. Only two funds have a 15-day return that is greater than zero. One is a money market fund. The other is Fidelity Select Medical Equipment (FSMEX).