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Partly Cloudy or Partly Sunny?



• The market has thus far remained in narrow trading range despite a plethora of market moving events over the past two months. Sufficient buying interest is needed and could come from either lower prices or significant improvement in the fundamental backdrop. Over coming weeks, it could be a combination of the two.

• A sharp move in either direction should provide enough emotion to generate another intermediate-term leg higher. No action (guessing) is needed until that sharp move takes place.

• Only a sharp move out of the range is likely to create a level of "fear" or "greed" enough to generate the next sustainable move. The increased volatility in the fixed income markets may be a potential catalyst. It is important to look to the longer-term picture before evaluating the equity reaction to the near historic Rate of Change (ROC) in bonds.

Near-term Could Be Partly Cloudy. President Bush begins a month long vacation and it seems to make sense. The last two months have brought significant intraday volatility and anxiety with very limited progress - despite the highly anticipated corporate profit and economic releases. Both have shown enough promise to keep the aggressive "it can only get worse from here" sellers at bay, while the limited actual improvement has kept the "it can only get better from here" buyers at bay. With both aggressive camps having been neutralized...well...the market as a whole has been stuck in the narrowest of trading ranges (Exhibit 1).

Exhibit 1 - The SPX remains in a narrow range...

This narrow range could be viewed as one of two ways based upon ones own longer-term view of market. The bulls would argue that it is normal and healthy consolidation after a high momentum rally, while the bears would suggest the lack of buyers at higher levels suggest waning interest and therefore an ultimate reversal of prices, especially given the intermediate-term overbought condition and loss of momentum (Exhibit 2).

Exhibit 2 - ...As it works off an intermediate-term overbought condition

Long-term Looks Partly Sunny. Over the past two months, we have outlined the "good enough" view; that the environment is "good enough" to keep prices higher, but is not good enough to kick start another sustainable rally. It seems the only thing that could create sufficient enough demand in order to generate a more sustainable move would be either lower prices or dramatically improved real fundamental progress.

It seems plausible the likely outcome could be a combination of the two. Recent economic data such as Retail Sales, Durable Goods and 2nd quarter GDP confirm what the FTN Midwest Research IMR (Independent Market Research) has been suggesting over recent months...there is moderate fundamental improvement over a variety of sectors. The question of whether this improvement, both on and below the surface, is likely to create potential investment paralysis over coming months as more evidence of economic improvement comes forth.

Signs of Skepticism. One thing is for sure, despite recent fundamental improvement, skepticism regarding its longevity remains high. Just after the positive surprise in the GDP was reported, analyst after analyst was talking about what happens after the current economic improvement is over. Just the tone of the commentary reinforces the view that stocks may have more room to the upside and therefore any price break, especially if violent in nature, would be used as an opportunity to accumulate versus a reason to panic.

Another example of the skeptical tone of the market was last week's focus on the spike in the Rate of Change in 10-year Note yields (Exhibit 3) and what it could mean for equities. This was perceived as a pending negative for the market, which may or may not be true. In a market looking for a reason to move out of the range, the spike in bond yields makes for a solid excuse. It is important in our view to take it a couple steps further.

First, spikes like the one seen recently have been followed by periods of relative stability in bonds, not periods of more pain. Second, when looking at the monthly data, the long-term impact on equities was mixed when the Rate of Change was this dramatic (Exhibit 4). If you take the only two prior examples of such a monthly spike in ROC, once the volatility in bonds (that created volatility in equities) was over, a sustainable move higher in equities began (Exhibit 5).

Create Plan of Action. In our view, the key to the transition environment in the economy and financial markets is to have a plan of action ahead of sharp move in either direction so as to remove any emotion as it takes place. As mentioned early, we wouldn't be surprised to see a sharp move down on a price break of the range, but the downside should be limited. All too often in the investment business, as stocks are going up, folks don't want to chase them higher and plan to buy their favorites or the market as it corrects. When stocks come back down to those levels, it generally is greeted by "well I don't want to be too early; this decline has more to go."

If you wished you were more invested as stocks were moving higher in May and June; you may get another chance to buy near similar levels.

Exhibit 3 - Bond Yield ROC spikes on weekly

Exhibit 4 - the spike needs to be put in perspective using the Monthly

Exhibit 5 - The results of a monthly spike in Bond yield ROC is mixed

Charts courtesy of Reuters Bridgestation

Good Morning Minyans
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