Nolte Notes - Stock Markets Bumping Along

By: Paul_J_Nolte

In keeping with the recent activity of the markets, the major averages took it on the chin this week, for reasons that remain somewhat of a mystery. Oil prices rose back toward the $70/bbl mark, however the pump prices have continued to decline every so slightly. Bond prices moderated from their rapid decline of the past few weeks. The economic reports continue to show an economy that is “bumping along” without the major potholes that many feared. However the rumblings over a housing market still not in recovery mode and the liquidation of Bear Stearns hedge fund (funded by a bunch of sub-prime loans) was enough to make the markets jittery and push them lower for the week.

The economic reports remain sparse through the holiday, although the Fed does meet (and shouldn't change rates) and their comments regarding the economy and inflation will be watched closely. A couple of weeks to go before earnings season swings into full bloom and we get to see how well many companies have talked down expectations only to beat them. Margin pressures are mounting with commodity prices rising and wages still rising near the rate of inflation. How much longer can companies report good earnings? We suspect we are coming to the end of that phase and disappointments are likely to mount in the coming quarter.

Many of our weekly and daily indicators have been deteriorating over the past six weeks, even as the markets move higher. However the SP500 has, for the first time since the end of February, closed below an average of the past 50 days. The steep trend from the March lows has also been broken and we can see a correction that could take the markets down at least another 3%. A 10% correction would put the market at the low end of a channel that has marked the bull-run since mid-2004. With the exception of the March correction, the SP500 has been trading above that 7% band.

Deterioration in the number of advancing stocks and the still persistent trend of volume expanding during a decline makes the market vulnerable to the 100+ point moves that we have been seeing in June. Investors will need to brace for additional volatility through the summer months, as the markets still have to sort out the economic landscape and the housing/sub-prime loan impact upon the economy (or more importantly, the impact upon hedge funds). We believe the markets are vulnerable – and have been for some time – to a large decline, however what event(s) are likely to trigger that decline and when it will occur remain elusive. For now, we are maintaining a relatively defensive stance in our investment approach.

The yield curve continues to move toward a normal sloping curve, with short-term bonds yielding less than longer-term bonds. Rumors that China is buying short-term maturities (thereby pushing yields down and prices higher) may be at the root of the more normal curve, however there continues to be default risk that is only now beginning to get priced into the markets.

For much of the past two years, the difference in yields between a government and below investment grade bonds has been very narrow – at or near historically low spreads. If we begin to see sub-prime loans become an issue, investors will once again demand that lower quality bonds “pay-up” for the risks investors incur by holding them – pushing prices lower and yields higher on the low quality issues. The safety of government bonds is well worth the lower yields for the peace of mind provided.

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

Copyright © 2007 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - 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.

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