Finance Banter

Sinister forces are at work in both the economy and financial markets. The devil is in the details of the just released employment report showing further job losses, yet an unemployment rate that fell to 9.7%. After all revisions to prior year data, it was noted that the US lost even more jobs than initially reported due to changes in the seasonal factors and the new business “birth/death” model. The devil in disguise may be China, as they were thought to be the global savior by purchasing nearly everything under the sun to keep their economic engines going. Comments over the past week about trying to slow growth/speculation in their financial markets dampened animal spirits here. Finally, the devil in the blue (and white) dress was Greece, as risk over debt servicing (ala Dubai) and will the European community back the country bonds forced investors to the “safety” of the US dollar and short-term bonds. Although the week also saw improvement in the manufacturing and service sector (via ism.org), declines in weekly initial unemployment claims unnerved investors even before the fuzzy monthly data was released. Economic data to watch this week will be retail sales (how much Prada can the devil wear?) and trade.

We highlighted the 1038 level on the SP500 last week as a likely resting point once the 1080 level was broken and at Friday’s worst, 1044 was as low as it could go before a last hour rally moved the markets to positive territory for the day. However, last week continued the trend of the past few weeks where volume expanded on market declines and contracted on advances. Although the averages were up on Friday, many more stocks finished down on the day on the heaviest volume of the week. The daily data (2-4 weeks) is now indicating that the markets could continue Friday afternoon’s rally, the weekly data (4-10 weeks) is still pointing down and suggesting that there is more to go before a more meaningful bottom is in place. The “magic” number for the SP500 is 1100, which marked the departure point for the market decline this week. It also marks a roughly 50% retracement of the market decline since mid-January and would break the current sequence of lower highs and lower lows. What has been surprising has been the rapid move from bullish to bearish in the sentiment readings, which could (perversely) provide some minor support for stock prices. A lot of excitement in the markets last week that ended with a modest decline, avoiding something that could have been very ugly.

The bond model continues to register a “buy” indicating that rates are likely to drop over the coming weeks. Last week we highlighted the declining CRB index and a likely further decline towards unchanged levels vs. a year ago. We are seeing the same trends in many of the underlying commodities, from gold to oil and copper. The big discussion continues to be when will inflation “inevitably” rear its ugly head? A rather simple answer is when the money poured into the financial system finds its way into the real economic system. For now, the monetary aggregates are contracting as is loan activity and consumers propensity is to save and not spend. So we are likely to see moderation in the inflation picture for much of this year meaning both interest rates and commodity prices are likely to fall further.

The correction of the past couple of weeks has hit the more cyclical issues hardest, as investors begin to rethink the overall strength of the economic recovery. Groups such as homebuilders, rails, commercial vehicles and steel were among the biggest losers in our ranking system over the past two weeks. Not surprisingly, more defensive groups like pharma, personal products and soft drinks faired well. That is not to say investors will be getting rich on these groups, just that they are likely to fall less as the markets correct. For example two drug companies, Merck and Pfizer (MRK, PFE) both have performed better than the markets since mid-’09, however have also been stopped at their very long-term 200-week averages and both have crossed below their shorter-term 50-day averages. Another more defensive group that looks a bit better relative to the overall market is the consumer non-durable group, led by Colgate (CL) and Proctor & Gamble (PG). Both companies have done well so far this year (although down) and have held their ground while the markets have fallen. The violent decline of the past couple of weeks is likely to reverse some in the weeks ahead and it will be how the groups’ shift that determines whether the rally is nothing more than a flash in the pan or something more lasting.

Volatility is back and making investors very uncomfortable. We are reducing foreign exposure in portfolios due to a rising dollar caused in part by concern over sovereign credit issues. We are likely to keep the cash out of the equity markets for a time, until the dust begins to settle. Bond investors are likely to see lower rates over the coming weeks and as such, should be locking in yields on bonds with 5-7 years to maturity.

Paul Nolte, Managing Director at Dearborn Partners, provides portfolio management services to individual and institutional clients and is a member of the firm’s Investment Committee.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

View more articles by Paul Nolte