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The Summer Wind


Bring it on Elmer!


Good morning. Meandering around NYC in ideal weekend weather, it was apparent that seasons are changing and summer finally appears within our grasp. As the warm air hugged giddy pedestrians, I couldn't help but wonder if a similar climate change is on the horizon for the financial markets. I mentioned recently the idea that the bond market could be THE chief tell for the equity markets and had been keying off the brokers, banks, REITs and semi's. That's certainly where the action has been in recent trade and after the surging 4/2 payroll data and 4/13 CPI / Retail Sales figures, yields have climbed about 50 bps on the 10 year note from 3.88% to around 4.34% on Friday. For their part, yields on the 2 year note have risen almost 40 bps from 1.624% to 1.989% over that short span.

It might make some sense to continue to monitor the spread between 2's and 10's (as well as junk spreads) as they are a reflection of the cost of capital and an indication of the liquidity environment - specifically the ability of the banks to employ the carry trade as a way of virtually printing money. In any event, the data has led to increased conjecture regarding the timing and magnitude of future interest rate hikes and served to further stoke the flames of the debate about inflationary pressures.

With rates still historically low, the key question becomes what investors will choose to do with their hard earned cash in light of the potentially changing dynamic. I would agree with the notion that a rise in interest rates doesn't necessarily imply that it will either be immediate or sizable (at least at first). Argue what you will about the appropriateness / wisdom or ramifications of Fed Policy, but the Fed typically doesn't set out to purposefully create shocks to the system. It is unclear when the Fed will act and a rise in rates may still be some time away. Rate hikes would also likely occur gradually in order to allow them to be worked into the system. So a few questions to consider then as we evaluate the current juncture...

Does a rising interest rate environment automatically put a cap on stock market gains? If it takes time for rate cuts to work into the system, then what's the relationship for rate hikes? Obviously the market is starting to anticipate higher rates, so what is the relationship between rate hikes and market tops with respect to timing? How much room do we have in terms of rising interest rates before a suffocating impact on investment is truly felt? What impact will the elections and fiscal stimulus (already in the system) have in terms of offsetting the near-term impact of rate hikes? What impact, historically speaking, do higher rates have on corporate earnings? If CPI is the gauge by which the Fed is measuring inflation, and that's not an accurate measure, than what is the better reflection (and what's the justification for not using it)? Isn't this all about the banks - as well as the impact higher rates would have on financing costs for lower quality issuers?

That last question causes me to continue to keep one eye on the Russell 2000 Index (RTY) as a potential tell. If we are in for a step-up in rates at some point, the bond market and typical income vehicles such as preferred's and REIT's could remain soggy. While the equity market would likely remain the place to be (with rates still historically low), the question becomes where (in the equity group soup) will investors go in search of returns. The recent action could be a signal of things to come, as investors may move out of high flying small caps, technology and financials and into more defensive, higher quality (less volatile, predictable earnings, dividend paying), issues in areas such as pharma / healthcare, energy, consumer staples, cosmetics / personal care, tobacco and food. Not sure if that plays out but something to be mindful of...

In the near-term, clearly the rise in yields has taken its toll, as expected, on the rate-sensitive names - specifically the financials, mortgage originators, homebuilders, utilities and REITs. The Philly Bank Index (BKX) cracked the 50-day (near 100) and fell about 5% to an intraday low of 95.50, before a relief rally brought it back toward 97.50. Citigroup (C:NYSE) is now sitting on key support around its 50-day ma at 50/50.17. The Philly Housing Index (HGX) is resting slightly above the 50-day (384.62).

Why is it so important to be ready for a shift in market conditions and continuously adjust risk along the way? Take a look at the MS REIT Index (RMS) which, after hugging a 52-week high, promptly lost about 16% of its value in the course of 7 trading sessions on the rate debate. Just further evidence that markets typically move to the downside far more rapidly than they do to the upside and you've gotta stay on your toes.

Oil is staring at $38 / brl again (March 17 highs) and if it manages to finally get thru that level (with the continued climb in gasoline futures) - I'm going to invest in a pair of roller skates as my primary means of transportation. The Philly Oil Service Index (OSX) has climbed thru the 105 level based on strength in Schlumberger (SLB:NYSE) [thru the 50-day and broke the downtrend], Weatherford (WFT:NYSE) [tickling resistance at 50-day ma 43.26], Smith International (SII:NYSE) [breaking out thru 55], and Halliburton (HAL:NYSE) [breaking out thru 50-day ma (30.28)]. The Amex Oil Index (XOI) reached a 52-week high on Friday, fueled by strength in Exxon Mobil (XOM:NYSE), Occidental Pete (OXY:NYSE), and Total SA (TOT:NYSE ADR) - all hitting new highs. Note that the IPAA Oil and Gas Investment Symposium runs this week (Mon thru Wed) - obviously a number of geopolitical and supply/demand related issues at work here - but we'll see if we got a little lift into the meeting that could set things up for a pullback.

We've had a close eye on the red Sox lately as they've stuck out like a sore thumb. Upon breaking the key 500 level, the semi's have had a pretty nasty chip slip giving up about 8% to touch support at the 200-day ma (574). KLAC Tencor (KLAC:NASD) [touching new low and clinging to last support area], Novellus (NVLS:NASD) [eyeing support at 30] and Applied Materials (AMAT:NASD) [broke the 200-day] were notably weak on Friday. We do have the semi book-to-bill report and Cypress Semi's (CY:NYSE) (fugly chart) analyst meeting today to wrestle with.

This market will have to do some feeling around this week. For sure, we had a bit of everything thrown at us last week and that will likely remain the case. The earnings parade continues in full gear with essentially everyone who didn't report last week on the docket. Rates completely overshadowed the earnings reports last week, which were generally good (sans Int'l Business (IBM:NYSE) and Nokia (NOK:NYSE)). Chairman Greenspan will head up to the Hill to talk shop on Tuesday (Senate Banking Comm) and Wednesday (Joint Economic Comm). We've got a flurry of Fed Heads also set to make guest appearances at various events throughout the week (note Mr. Bernanke on Thursday). Beeks swings by with leading indicators (Mon), Fed beige book (Wed), initial claims (Thurs), and durable goods (Fri).

It's been some choppy water lately for sure so be careful and selective. As always, we'll scan the action and highlight the relevant info as it all unfolds. Good luck.

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