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.

Last Week in Review

Last week in every market segment was down including energy, materials and utilities. Overall, it was a tough week with the S&P500 down 3.1%, Nasdaq fell 2% and the Dow Jones Industrial declined 3.8%. Year-to-date the S&P500 is now down 9.3%. Small caps continue to outperform large (less negative) and growth is trouncing value investing. Market jitters continue and the bears are winning.
Oil troubles continue with prices rising to new highs. Increasing energy prices have stoked inflation fears. The numbers of speculators in the commodity markets is growing rapidly only adding to the feeding frenzy. In addition, escalating tensions between Israel and Iran is adding instability to an already rocky oil market. The scuttlebutt is that Israel will bomb Iran with assistance from the U.S. in the next six months. Oil prices will soar to over $200 a barrel if Iran is attacked. Baring an attack, the energy markets look very frothy and should retrench from these lofty levels.
Problems in the financial sector persist. Banks have only written off one-third of their bad investments and the housing market is rapidly disintegrating. These problems will not be fixed overnight. Until the housing market begins to recover the economy and markets will stay in turmoil.
Inflationary forces continue in the developed and developing world is reaching the choking point. Many economists feel inflation is not that bad because it has not spread to workers. Rising unemployment is keeping wages down. So in economist-speak inflation is not so bad.
In the real world the problem is that the collapsing housing market in conjunction with rising food, energy and healthcare costs have taken the consumer out of the market. I know I write this all the time but two thirds of our Gross Domestic Product (GDP) is generated by consumer spending. Consumers aren’t spending (look at the recent performance of retailers and automobile manufacturers). Consumer lead recessions (vs. business lead recessions) are always deeper and take longer to recover. It takes more time to build up consumer sentiment and get consumers spending again. This is not going to be an easy and quick V-shaped recovery. It will probably resemble a very wobbly wide W-shape.
The Fed is talking hard ball and many of its members want to raise the Fed Funds Rate when they meet. It will be difficult for them to raise rates any time soon because it would bring this fragile economy to a screeching halt. Instead, they will have to keep rates where they are and if things get worse they may have to lower rates again.
In the short run, the market will remain choppy with equities swinging significantly down on bad news and moderately up on good news.
I will be in Chicago this week at the Morningstar Conference. I hope to meet with numerous portfolio managers of mutual funds. I will be reporting back my findings and interviews.

Oil Prices Drop, England Raises Interest Rates and the U.S. Stock Market Rises

There are two big news stories today impacting the financial markets. The first, the price of crude oil continues to fall. The extent of the correction can be seen on the adjacent chart. High oil prices are considered by many economists to be a tax on the economy. It drags down profitability across many industries even the service sector. Falling oil prices are good news and the market rose in response. The chart is the price of Crude Oil (NYMEX) and can be viewed on the WSJ site through the link below.

http://online.wsj.com/mdc/public/page/mdc_commodities.html?mod=mdc_topnav_2_3000

The second story is the Bank of England raised their interest rate. This is the English version of our Federal Reserve changing the prime rate. By raising their interest rate, the English have made some of their investments more attractive. So the pound rose against the dollar and the euro. It also caused U.S. Treasuries to fall as investors moved funds into English bonds.

You can read more about this story on the International Herald website.

http://www.iht.com/articles/ap/2007/01/11/business/EU-FIN-ECO-Europe-Interest-Rates.php

Libby Mihalka

The Financial Pragmatist