The major market indices finished the week broadly lower. Volatility remained elevated on growing uncertainty over whether the $1 trillion EU/IMF bailout package will have the teeth to remedy the growing fiscal problems in southern Europe.
The flight-to-safety trade was in high gear last week as investors shed risk assets (stocks, commodities) in exchange for the safety of the U.S. dollar and Treasuries. The yield on the 10-year closed at 3.23%, down from 3.45% on the prior Friday, and has fallen from nearly 4% in early April (price and yield move in opposite directions).
The recent weakness has officially pushed the Dow, S&P and NASDAQ into "correction" status (a correction is defined by a 10% pullback from a prior peak). This is the first 10% correction since the market rally began in March of 2009, and was long overdue, in our opinion.
While the recent weakness in the markets has been trying, it should be acknowledged that a lot of good news has been priced into the markets over the past 14 months. Corrective phases are almost like a flu shot -- while the shot itself is painful, it is a necessary evil before the healing process can begin. In other words, the consolidation process -- while painful to go through -- provides a mechanism to filter out the weak holders and quick money guys, and it allows shares to be repositioned to longer-term investors at more attractive price points.
The silver lining to the recent market turmoil has been the significant pullback in oil prices and the downtick in interest rates. The former should set the stage for lower gasoline prices as we head into the summer driving season, while the latter should help keep mortgage rates and other consumer lending rates at very low levels.
| Index | Closing Price 5/21/2010 |
Week Ending 5/21/2010 |
Year to date through 5/21/2010 |
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| Dow Jones Industrial Average | 10193.39 | -4.02% | -2.25% | ||
| Wilshire 5000 Total Market | 11240.13 | -4.50% | -1.59% | ||
| S&P 500 | 1087.69 | -4.23% | -2.46% | ||
| NASDAQ Composite | 2229.04 | -5.02% | -1.77% | ||
| S&P/TSX Composite | 11521.35 | -4.11% | -1.91% | ||
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FOMC Minutes. Last week the Federal Open Market Committee (FOMC) released the minutes from its April 27/28 meeting. The minutes stressed the need to keep interest rates at exceptionally low levels for the foreseeable future. This was accompanied by a modest uptick in the group's view on economic growth and a downtick in the forecasted year-end unemployment rate. The committee now believes that economic growth, as measured by the gross domestic product (GDP), will grow 3.5% in 2010 versus its earlier estimate of 3.2%. In addition, the unemployment rate, while expected to remain elevated, is likely to end the year at 9.1% versus the current (April) rate of 9.9%. In addition, the committee predicted that inflationary pressure will remain subdued.
The last point was underscored on Wednesday when the Labor Department reported that the consumer price index (CPI) fell 0.1%, while the core rate (which excludes food and energy) was unchanged. On a year-over-year basis core inflation is up only 0.9%, the lowest rate since 1966. The Federal Reserve Board has a dual mandate of price stability and full employment. The low rate of inflation should continue to allow the Fed to keep its easy money policy in place through at least the first quarter of 2011.
Technicals. Considerable technicals damage was done with last week's sell-off. The S&P 500 broke below its 200-day moving average, a sign that the longer-term uptrend may be in jeopardy. On a more positive note, at least from a contrarian standpoint, the weakness has also pushed the market into a severely oversold condition. When looking at the percent of S&P 500 stocks trading above their 50-day moving average, it shows that less than 6% of stocks are above that level. This is very similar to the level that was reached in March of 2009 when the bull market rally kicked off. While past performance is no guarantee of future results, the near-term oversold nature of the market should help buffer the pace of further declines.
Fear returns, long live fear. The March 8 edition of the Weekly Viewpoint featured a paragraph titled "Lack of fear is scaring me." The gist of the article was that investor complacency was at very elevated levels, as witnessed by the Chicago Board Options Exchange Volatility Index -- also known as the VIX and often referred to as the "Fear Index."
As pointed out in these missives over the past couple of years, fear and greed are often determining factors in making investment decisions. These emotions also tend to be contrarian in nature, meaning fear is almost always lowest near market peaks and almost always highest near market troughs. The good news is that fear has returned to the marketplace; in fact, since early March, the VIX Index has gone from 17 and rose as high as 46 on Thursday. There is an old Wall Street adage that states bull markets climb a wall of worry. If this is the case, the recent surge in the VIX Index may be a precursor to a resumption in the bull market rally.
Interbank lending rates. The recent stress in the European markets has resulted in a surge in interbank lending rates (i.e. the rates that banks charge to lend to each other). The London Interbank Offered Rate (LIBOR) for overnight loans has almost doubled since late-February, a potential sign of building stress and a reluctance to lend.
Lending and liquidity are vital components (the grease, if you will) that keep the economic wheels turning. While rates have surged we must also keep things in perspective. To wit; at the height of the financial crisis, the overnight LIBOR surged to 6.875% versus the 0.30% current rate. In addition, over the past five years the overnight LIBOR has averaged approximately 3%. We will be monitoring interbank lending rates very closely over the upcoming weeks for further signs of building stress. However, we do not believe the recent uptick in rates is enough to derail the financial system or bring it to a screeching halt as was the case back in September/October 2008. In addition, the current low levels of lending rates are also a testament that the banking system is in much better financial shape then in late-2008.
Capitulation? While many factors (Europe, China, Regulatory reform, etc.) can be blamed for the recent bout of weakness, Thursday's 376-point shellacking in the Dow seemed to be more driven by fear. Corrective phases typically don't end until the last bull throws in the towel. While it's impossible to say whether the selling was the capitulation that marks a near-term bottom, there were capitulation-like characteristics evident with many of the traditional "fear fulcrums"" signalling extreme levels of fear, to wit:
- Up volume only accounted for 2% of total volume;
- The VIX rose 29% and is back above 40 (an area of extreme fear);
- Market breadth on NYSE was extremely negative as declining issues swamped advancers by a 15:1 margin.
Earnings season wrapping up. As of Friday, 486 members of the S&P 500 have reported first-quarter results with 77.5% beating analysts' expectations. This is well ahead of the normal 61% beat rate. Overall earnings are up 52.9% and well ahead of the estimate for 35% growth coming into the quarter. In addition, revenue growth is well ahead of analysts' expectations, suggesting that the better than expected trend in earnings is not just a product of cost-cutting initiatives.
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