NOLTE NOTES - The Manic Markets

By: Paul_J_Nolte

Expect the unexpected. Little did we expect that subsequent to a new all-time high in the Dow, we would be talking about the beginnings of a bear market merely a week later. While we have been cautious about the market for some time (some argue too long!), the concerns that we have been expressing about the markets as a whole all came to bear over a few short days. So now what? The economic news last week, specifically the GDP figures, showed an economy that still has some life, however the focus is now exclusively upon housing and borrowing.

While we expect that the economy is in the process of slowing, we have long argued that housing would act as a long-term cap on economic growth as not everyone is over extended with borrowing on their properties. This coming week will be loaded with the usual beginning of the month economic reports – from employment to reports on services and manufacturing. Given the precarious position the market is in (after closing down hard on Friday) any worse than expected news about the economy will foster a new round of selling first, asking questions later. What we are seeing in the markets does not reflect the economic activity of the day, any more than the gains of the past year resembled the past year's economy.

We figured the market would test the bottom of the recent two-month range over the next few weeks, not the next couple of trading sessions. The market is now facing the average of the past 200 days – a spot that has contained (within a 4% “tolerance) every market decline since the beginning of the advance in 2003. We are expecting a rather sharp rally early in the week, as our daily technical data now matches many of the prior declines before they turned around. That is not to say that Monday will be a tough day, as Friday's close indicating no one was willing to hold position over the weekend, fearing the collapse of a couple of deals due to lack of financing.

The characteristics of the markets are also beginning to change, as small cap and value stocks have been hurt the worst during this decline. Generally during market declines, the best performing sectors/groups/asset classes are the ones that then lead the market out of the abyss. We are in the midst of such a shift – from small to large and from value to growth. Which actually makes sense – value is loaded with financial holdings and small cap has little exposure to the foreign markets that continue to grow faster than the US.

Given the large stock market decline and bond rally, one would have thought the bond model would be on a buy signal. Surprisingly it actually got a bit worse, falling to a still negative reading of “1”. Inside the model, we look at the utility average (had a dismal week), commodity prices (still rising) corporate bonds (investors are fleeing) and treasury yields of both short and long-term bonds. The market was focused on 10 year bonds, as yields dropped again to levels not seen in two months.

However short rates perked up again and the yield curve once again is inverted – meaning the risks for a recession have increased a bit. Also, the futures indicating the likelihood of a Fed cut (which have been buried at zero for weeks) suddenly are showing an increasing possibility rates are cut this year. Such is the manic market!

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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