Market Commentary for the week of January 29, 2007

Is a market selloff justified?
As proof that the market is looking for any excuse to sell, last week’s performance in stocks was tribute to an inverse response perspective. The latest labor market data portrays a slowing economy, yet the Federal Reserve is dropping hints that its fight on inflation is not yet over.

A slight increase in interest rates on Thursday set off an across-the-board selloff, stopping the early January momentum in its tracks.

The government’s own data doesn’t support economic expansion.
Curiously, as numbers feed in slowly from last year (2006), the profit and growth picture looks even more cloudy relative to why the market is exploding and why the Fed thinks it needs to quell excess growth.

Over the last two months of 2006, payrolls stagnated (with the exception of Wall Street bonuses), growing at an annual rate of less than 2%. A deceleration in jobs expansion coupled with a more conservative bias for capital spending puts annual Gross Domestic Product (GDP) below 3%, suggesting that a slowdown is in the offing, if not already here.

Yet the Fed wants to fight slow growth with even slower growth by raising interest rates to counteract the effects of inflation upon economic activity. The trouble is that the kind of inflation the Fed seeks to attack is not borne out of excessive consumer spending or demand, but rather from a hoarding of natural resources by foreign enemies, and nefarious domestic corporations.

Profits are not always where you find them.
The full impact of this greed can be seen in the localization of profit in the tangible assets companies while the cyclical and consumer-driven equities languish. This concentration of wealth can intensify the appearance of growth-related statistics, but in truth it only masks the effects of diminishing discretionary wealth and negative psychology.

Upside resistance or support.
Yet, the continued outperformance of stocks, despite indications that valuations are stretched, remains the story. It appears, from my work, that the elasticity of share prices is being severely tested. When measured against more benign statistics such as earnings acceleration rates, revenue growth, or net profits the market is at historically dangerous resistance points.

This is not to say that I favor abandoning stocks altogether, nor that there has been a fundamental change in the methodology for evaluating cyclical performance characteristics. The case might be made, in fact, that as the market contracts laterally, not cyclically, we are creating a new floor of support building upon previous upside resistance levels. Using historical comparisons as a basis of study, I would posit that while this could be the case, the likelihood that it is true is quite small.

Recall that interest rates are rising, not falling, and that the number of stocks advancing versus those in decline are outnumbered nearly 15 to 1 to the downside. In other words, I consider the early year new highs to be aberrations of the facts, not corroborative.

Diminished earnings acceleration might be negative for stocks.
In the current climate, earnings forecasts are suffering from poor demand, global competition, and price pressure. The burden upon the consumer is too heavy to rescue stagnant growth by spending us back to prosperity.

The impact of rising commodity prices upon global commerce is reflected in the fact that nearly all of the 40 global market baskets I study are in long term declines, or “distribution” patterns. Acknowledging that there are always individual equities that are exceptions to a broader rule, I find pockets of potential in biotech, land and water resources, agriculture, energy, and telecommunications.

The process of identifying those companies with expectations for earnings acceleration and capital gains potential is the mandate I am given by my clients and the essence of my methodological study.