Turnaround or Bounce? Look To The Banks

Last week’s positive move in the stock market was overdue, but it is unclear whether this is the beginning of a turnaround or merely a bounce from oversold conditions. There is some evidence that market conditions are improving. Last week’s rally was broad-based and volume was heavy, which are strong technical factors. Additionally, lower-quality stocks have been outperforming, which typically happens as markets turn around. However, it is very possible that we are still bottoming-out.

There was good economic news last week. Retail sales figures were surprisingly positive. January’s data was revised to show that sales actually rose, and February’s numbers were down only slightly. All told, it appears possible that overall first-quarter retail sales growth will net out to around zero, a much better scenario than was widely anticipated only a few weeks ago.

Today more good news. An unexpected rise in housing starts and a more moderate increase in wholesale prices point toward a brighter economic outlook. Another plus, the market appears to have leveled off before the recently passed stimulus package has started to have any effect.

That said, the overall economic environment remains troubled, and as Federal Reserve Chairman Ben Bernanke said last week, “Until we stabilize the financial system, a sustainable economic recovery will remain out of reach. In particular, the continued viability of systemically important financial institutions is vital to this effort.” The banking system needs to stabilize before we see a full recovery.

Last Week in Review, Market Shorts at Bearish Levels

Another icky week and more worries. Once again stocks declined last week in the face of credit concerns, recession worries, high oil prices and inflation fears. The S&P 500 fell 1.8% during the week to 1239. we are firmly in Bear territory now.

As we have discussed before the Fed is between a rock and a hard place. It cannot serve dual mistresses of low inflation and economic growth. So in order to keep the peace it will have to keep the Fed funds rate at 2%. It will continue to aggressively use what ever tools it has at its disposal to create liquidity and fight off market instability. We will continue to see the Fed step in as necessary as it did this weekend to provide liquidity to Fannie Mae and Freddie Mac.

The next chart highlights the amount of short interest in the market today. This measure depicts the percentage of trading volume that is betting the market will go down. Historically, levels this bearish have been fore bearers of future market rallies.

So what is the outlook from here? Presently, the U.S. equity market is in the process of making its third bottom (the first occurring in mid-January and the second in mid-March). The next notable move will probably be up as fears begins to abate.

As long as oil prices keep rising, stocks will remain under pressure, central banks will be unable to act and the risk of recession will grow. In the long term, for the markets to recover will require oil prices to abate which means the demand for oil must subside. Demand pressures should subside as the global economy continues to slow. It will become ever more difficult for oil prices to continue their unprecedented drive higher as demand pressures abate. The bottom line is that a correction in oil prices is a necessary if the world economy is to avoid a major slump, for inflation to decline and for equity markets to enjoy a sustained rally. At this point oil prices haven't shown any weakness so it is unclear when things will begin to get better.

It is Time to Rebalance

At the end of last week, the indices were all moving towards new highs. Despite slowing earnings growth the market just keeps heading up. While the long term trend is healthy, I think we are in for some turbulence. Usually when the market moves aggressively ahead, pushing toward new highs, after a while it takes very little news to derail the train. It seems inevitable as we head into the summer that the market will consolidate its gains by pulling back a little. The market will then take the summer off to digest the latest gains.

While the majority of the economic news remains positive there are negatives looming out there. For instance, there is slower U.S. employment growth, tightening credit, higher gas prices, slowing corporate earnings growth, and falling housing prices). Despite the negatives, the current situation does not warrant selling and walking away. Corporate earnings are still strong and P/E ratios are still reasonable (see chart). The current market conditions do warrant implementing a strategy of rebalancing and trimming. Increasing cash holdings over the next few weeks will enable an investor to take advantage of any pull backs. The catalyst(s) that could spark a correction is (are) unknown, but it could finally be the U.S. consumer cutting back or disappointing economic data.

It is likely that turbulence will be minor should it happen at all. The new global economy will continue to perform well pulling the U.S. market along with it. The story here is really the global economy and not just us anymore.
For right now, the market is still hot because of accelerating merger-and-acquisition activity. As of the end of last week the mid cap market has been blazing hot since the start of the year. In the last few weeks large cap domestic stocks have picked up the pace. It is very unclear whether large caps will finally outperform small and mid caps this year. It is inevitable that large caps will at some point outperform its small cap brethren in the future due to valuation metrics (see past blog postings for more information). International stocks are still chugging along with the MSCI EAFE up approximately 8% for the year. Bonds are showing some life with the Lehman Bros Aggregate index up almost 2% year-to-date.

Analysis of Bernanke's Inflation Outlook

Here is the transcript from an interview from last nights Nightly Business Report on PBS.
This discussion is interesting because it shows the current debate concerning the strength and direction of the markets. Battipaglia's outlook is very pessimistic and he currently has over 30% of his client's allocation in cash (50% of his client's 60% equity allocation is in cash plus a percent of the bond portfolio). His firm is really expecting the markets to correct substantially. Market timing, to this extent, leads to under performmance.

Enjoy
The Financial Pragmatist
Libby Mihalka

Joe Battipaglia of Ryan Beck & Brian Wesbury of First Trust Advisors
Analyze Fed. Chairman Bernanke's Inflation Outlook

Wednesday, March 28, 2007

SUSIE GHARIB: More analysis now on Bernanke's testimony today and market reaction. Joining us, Joe Battipaglia, chief investment officer for Ryan Beck and Brian Wesbury, chief economist at First Trust Advisors. Brian, Joe, thanks for joining us.

BRIAN WESBURY, CHIEF ECONOMIST, FIRST TRUST ADVISORS: Good to be with you.
JOE BATTIPAGLIA, CHIEF INVESTMENT OFFICER, RYAN BECK: Good to be with you.

GHARIB: Brian, let me begin with you. Do you agree with Ben Bernanke's assessment of the economy that inflation is the risk of not weaker growth?

WESBURY: I do. I think that we've seen a slowdown in housing. We've seen what I would call an inventory correction, which is caused industrial production and durable goods orders to fall over the last few months, slow down the economy a little bit in the last few months. But the real risk to the economy in the next six, 12, 18 months is inflation.

GHARIB: Joe, Wall Street seems to have thought that that slowdown in housing, now that the economy is really slowing, evidenced by all the sell- offs we've had this week. What's your analysis of what Bernanke said?

BATTIPAGLIA: The street wants it both ways. They want a soft economy and ultimately rate cuts and what a good situation that is for stocks. My worry, actually, is the economy. The Fed has never engineered a soft landing. The data is more troubling than they are letting on too. They've already changed their language to that effect and I think it's a credit- driven problem in that consumers are tapped out, and so this may well be a consumer-led slowdown with the potential for a recession at 50 percent. The market certainly not looking for that and that's what's going to be more troublesome in the next several months. Add to that the persistence in inflation. You've got a very dangerous mix here.

GHARIB: But Brian, the message from Bernanke seems to be that the next move that the Fed makes on interest rates, when it does decide to move, that it will be up. It will be a rate hike not a rate cut. Is that your take on what Bernanke said today?

WESBURY: Well, I would argue that what he really said is that he wanted more flexibility. In fact, that's almost a direct quote. And that's why they sort of pulled back. But more importantly, one of the things he wanted to do was have the market stop being telegraphed the Fed's next move. He wants the market to be a little more uncertain about what the Fed might do. And one of the reasons that he wants that to happen is he wants long-term interest rates to go up. Remember, Alan Greenspan called the low, long-term interest rate the conundrum. Ben Bernanke has theorized that maybe it's happening because of a global savings glut or something like that. He's trying to get long-term rates up and one of the ways to do that is to increase uncertainty in the markets and I think that's one of the things he's trying to do today.

GHARIB: He did say that. He said he's going to give less guidance on interest rate moves. Joe, what does that mean for the market? Is it going to be much more volatile going forward?

BATTIPAGLIA: Oh, I would say so because if he is data centric here and looking for the next bit of news on the economy and on inflation, then he's no better off than the rest of us are in trying to figure out what happens next and right now his credibility is on the line because on the one hand, he wanted to be more transparent. If you want to be more ambiguous, that's not transparent. And the other is he wanted inflation below 2 percent but he doesn't have that. He's at 2.7 or 2.3, depending on how you measure it. Credibility at the Fed is at risk, Ambiguity is a problem and the economy itself has got very weak signals coming on, six months of slowdown in durable goods and a consumer that is gliding down the path of less houses being bought, less cars being bought, retail sales slowing down.

GHARIB: Brian, Bernanke also said that he didn't see any evidence that this whole sub-prime mess is affecting the broader economy. Is that really the case or was he just trying to reassure everyone?

WESBURY: No, I think he's correct about that. I think the sub-prime issue is a problem, but it's not a problem that will have a contagion effect that drags the entire economy along. And I think this is an important point. One of the reasons that we're in the mess with mortgages and housing that we're in is because the Federal Reserve lowered interest rates to 1 percent back in 2003. You can't drive interest rates down that low without causing people, some people to make decisions that they can't live with if interest rate goes back to normal and that's exactly what's happened. But interest rates today aren't high. And that's why I won't go as far as Joe does. Interest rates today, in fact, are still very low, especially given the inflation rates that we have seen. And, therefore, I don't think we're on the front edge of a recession or a big consumer--

BATTIPAGLIA: Here's the tip of the spear on this. I need to interrupt because most people are saying the same thing, except that the biggest asset that people own are their homes. Those prices are only starting to fall and they fall by 5, 10 or 15 percent or more depending on the market. And interest rates on the teaser side are going to be adjusted up, even with the low rates that Brian speaks to, they're going to double or triple from here and they can't refinance because their home values --

GHARIB: Joe, let me jump in. We just have a few seconds. Real quickly Joe, are you changing your investment strategy because of your views on what Bernanke said and the economy?

BATTIPAGLIA: We came into this with 60 percent equities 40 percent in defense of asset classes. In our equity programs we're at 50 percent cash looking for future opportunities. So we re definitely defensive and we've lowered our S&P target for the year down to 1430. So we're essentially looking for a flat year.

GHARIB: We're going to have to leave it there. Gentlemen, thank you very much, I appreciate your thoughts.

BATTIPAGLIA: You're welcome.

GHARIB: My guests tonight: Joe Battipaglia, chief investment officer for Ryan Beck and Brian Wesbury, chief economist at First Trust Advisors.

Weekly Review and Outlook

Here is the weekly review by Bob Doll is Vice Chairman and Global Chief Investment Officer of Equities at BlackRock Investments. I read alot of summaries, this one captures all the major market highlights and I agree with his insights. Happy Reading!

The Financial Pragmatist,
Libby Mihalka

Blackrock Commentary
Disappointing retail sales figures, ongoing problems in the subprime mortgage
market and higher inflation numbers all pushed stock prices lower last week, with the Dow Jones Industrial Average falling 1.4% to 12,110, the S&P 500® Index declining 1.1% to 1,387 and the Nasdaq® Composite dropping 0.6% to 2,373. After last week’s declines, stocks are down just over 2% for the year and are about 4% lower than their highs for the year.

The corporate earnings picture has changed somewhat over the past few weeks. From the second half of last year through early February, consensus expectations for 2007 earnings growth hovered just over the 10% mark, but then began falling. Expectations have since stabilized at around the 6.5% mark, close to where we forecasted they would be at the beginning of the year — certainly lower than in previous years, but still at a positive level.

The idea that the economy is slowing is not the debate these days, given problems in the housing market (and the associated financing issues), slowing manufacturing activity, declining retail sales and some evidence of a weakening labor market. The question facing investors now is: Does the slowdown represent a transition from a few years of above-trend growth to a period of more sustainable, but slower growth, or does the slowdown indicate that a recession is on the horizon?

Concerns over the subprime lending business have highlighted the possibility of an economic recession. Up until now, problems in the housing market have been relatively confined, and the residential real estate slowdown has not had a significant impact on the overall economy. Many observers, however, are worried that tightening lending standards could make it more difficult for the housing market to recover, potentially triggering additional credit problems and resulting in a recession. In our opinion, this outcome is unlikely. Despite all of the problems
in the housing sector, consumer spending levels have remained reasonably strong, corporate balance sheets are still in good shape and non-U.S. economies (particularly developing economies) also are quite strong. We believe that these positive factors will outweigh the negatives and that the U.S. economy will avoid a recession, although we believe a “growth scare” could still rattle the financial markets. The Federal Reserve will be meeting later this week, and we expect that the central bankers will begin adopting a more dovish tone given increased signs
of economic weakness. The Fed remains concerned about inflation, but in our opinion, inflationary fears are easing. We believe the Fed will enact an interest rate cut before the end of the year, which would help support equity markets.

Against this backdrop, we continue to believe that the long-term outlook for stocks remains good. Although we recognize that a number of risks remain, and we retain our view that short-term market action is likely to remain choppy, we do not believe that the bull market we have been experiencing since late 2002 is set to end anytime soon.