Market Commentary for the week of February 26, 2007

Buffeted by worse than expected consumer price data (CPI) released by the government last Wednesday, the markets first rose, then retreated towards defensive, inflation sensitive sectors. Although I have been forewarning against such a rise in inflation, the data, and the reaction to it, only serves to reinforce the volatility of owning stocks, and the severity of the negative economic data supporting them.

As the markets rise higher (setting new benchmarks twice last week, for example) the “wealth effect” becomes a self-fulfilling prophecy. “Either you’re in the market or you’re not” is not just a statement of fact, it has almost become a mantra for justifying excessive speculation. The real question is whether we are sustaining a bull leg, or contributing to a negative aftermath which might follow.

What’s the choice?
I believe that we are experiencing a struggle between the expectations of profit growth versus the economic reality of low interest rates and poor alternatives. The most modest economic news can be turned into a buying frenzy in the right vacuum. Even as the deficit (person and Federal) grows, demand wanes, and GDP decelerates, the Dow Jones rises. My analysis shows, however, that the breadth of participation at these record levels is quite shallow. In fact my figures indicate that the balance of “new high” equities is offset by stocks topping or in a decline by nearly 15:1 to the downside. In other words, this rally may not be the rally. The advance/decline line in this new high stratosphere is historically quite feeble.

Indeed, I would like to see the rally confirmed by greater breadth and a closer correlation of earnings acceleration patterns with price increases.

Profits are shifting.
Interestingly, the U.S. economy stands as a bastion of innovation and hope for emerging markets. But the subtle message being taken from global equity performance is that the U.S. is not the only game in town. Nearly 15 percent of this quarter’s Arlington Econometrics “recommended” equities are non-U.S. companies. Domestic imbalances in demand, currency valuation, and production capacity move the momentum data further away from traditional U.S. sector rotation and towards more non-traditional foreign investment, such as communications satellites, pharmaceutical research and alternative energy resources.

I am aware, too, that the alternatives to stocks are not attractive. Watching the Fed prop up the equities markets for the last half-decade with lower interest rates might be the antithesis of base-building, in the classic sense. Without traditional alternatives to stocks, the void is being filled by speculators, mergers and acquisitions, private equity takeovers, and share buybacks, all caused by or benefiting from the low cost of money. Having played its hand, the Fed exacerbated the “new high” dilemma by allowing equities to climb without retracement thereby skewing cyclic phase models towards the upside.

It’s a chilling thought.

Buoyed by exorbitant expectations and nearly replicating the mania of 1999-2000, the market stands poised either to break out further to the upside, or breakdown in a linear response to unsustainable valuations.

In or out?
For my part, I am using the current momentum to pare down equity exposure and to lock-in profits for the near term. It’s better to prosper from the market’s exuberance than to be sucker punched by it later.

My measurements do not specifically indicate a downward path from here, but neither do they indicate a sustainable rally is likely. Using the Utility stock average as a surrogate for bonds, for example, I am seeing indications that bond yields are only entering into a secular long term upward bias. This might cool off stocks somewhat, as higher interest rates on time deposits could become competitive parking places for short term cash.

Nothing says “capital gains” like earnings acceleration. In this environment of nascent inflation and price pressure it becomes increasingly less likely that all sectors are going to rise in unison.

Instead, I am looking for defensive, back-end leadership in Basic Materials, biopharmaceuticals, global telecommunications, agriculture, and Energy.