Schizophrenic Market

Wall Street went to bed last night fairly confident that producer price inflation to be announced this morning would be flat — no increase, no decrease. They figured they’d get some respite from raging inflation.

But when they came to work this morning, they found precisely the opposite: The US Labor Department has just announced that producer prices jumped 0.7% in October, far worse than expected.

Sure, the so-called “core” inflation (minus volatile items like food and energy) was tame for finished goods. But for core intermediate goods, the fires of inflation were hot — up 1.2%. … and for all intermediate goods, even hotter — up a full 3%.

This means no slowdown in inflation, no end to the bond-price decline, and no end to rising interest rates.

Result: The stock market is getting more schizophrenic by the day.

Sectors benefiting from inflation are mostly going up … and sectors hurt by inflation are mostly going down.

We have Big Oil announcing record-smashing profits … and giant GM sinking toward bankruptcy.

We have high-techs trying to recover … and PCs getting clobbered.

But the S&P, the Dow and the Nasdaq don’t reflect the market’s split personality. Instead, these broad averages add together all the pluses and the minuses, combining them into a single, not-very-meaningful, blur.

So every time I venture to make a short-term forecast on the Dow or the S&P 500 Index, someone ought to smack me.

A few weeks ago, for example, I got what looked like a clear signal that the S&P 500 was headed straight down.

The index had broken below a long, apparently significant, three-year trendline. It did not look good, and I said so.

But for now at least, it looks like I may have given too much credence to this broad average in a schizophrenic market.

The S&P promptly turned around and regained its upward trend. So my signal was either false … or premature.

But if you look at the broad market over a longer time horizon, you see a different picture entirely:

A market still struggling to dig itself out of the deepest bear market since the Great Depression.

Indeed, the S&P plunged in half between 2000 and 2002.

And now, even after three long years of rally, it has done little more than recoup about half of that decline.

It could rally further. But even if it does, it’s still not exactly a pretty picture overall.

Plus, it gets uglier when you consider some of the underlying facts:

Fact #1. Much of the S&P’s rally since 2003 was stimulated by the lowest interest rates in nearly a half-century. Now that stimulus is being removed.

Fact #2. Tax cuts also played a role, especially in goosing up consumer spending. But those are unlikely to be repeated.

Fact #3. The housing bubble put more money into the hands of consumers and investors than any asset boom in modern history — a huge factor in the growth of the economy, the recovery of corporate profits, and the stock market rally. That stimulus is also going away.

My advice: Continue to look behind the averages, focusing on the weak or strong sectors, and investing selectively …

Banks:
The Big Squeeze

The stocks of banks and mortgage lenders that cater primarily to higher-risk borrowers have gotten clobbered in recent months.

These are the financial institutions that were in the forefront of the mortgage bubble, dishing out loans with wild abandon, using every gimmick in the book — and not in the book — to get their customers to borrow more money.

But now, those same banks are getting squeezed — from two sides.

On the one side, the banks are being squeezed by borrowers defaulting in record numbers, leaving them holding the bag with loan losses.

Think about that for a moment.

There’s a big wave of delinquencies, defaults and personal bankruptcies in America. And it’s all taking place in a supposedly “strong” economy. So imagine what might be in store for these banks if the economy weakens!

Meanwhile, on the other side of the squeeze, the banks’ borrowing costs are rising, the natural consequence of the Fed’s 12 rate hikes.

Sure, the rate hikes have only been a meager quarter point at a time. But the end result is that the banks’ borrowing costs are now as much as four times higher than they were last June. Meanwhile, the yield the banks are earning on their loans and investments have barely budged.

This is the big squeeze at the banks, and the shares of the higher-risk banks are already beginning to reflect it.

When it comes to the large banks, however, Wall Street folks don’t seem to care much about all this — yet. Nor do they seem to mind the fact that bond prices, which usually pull down the value of bank stocks, have been falling steadily, taking still another header yesterday.

After all, the big banks ARE Wall Street. The big banks are the ones generating most of the research and giving institutional investors a lot of their investment ideas. So it’s not unusual for them to fall in love with their own stocks and have a little fling once in a while.

JP Morgan’s shares, for example, have jumped sharply in the last few weeks.

But the rally is not nearly enough to change the sideways pattern in JPM that has prevailed over the past couple of years.

Ditto for most other major bank stocks — a sharp rally in recent weeks, but still not convincing for the long term.

Meanwhile, the vise is tightening. So if anything, I think this is an opportunity to get OUT of bank stocks if you own them. And for speculators seeking to make some nice, short-term profits, this could be an unusual opportunity to buy put options on the stocks of major banks.

Energy:
No End to the
Long-Term Uptrend

While bank profits are in a squeeze, energy company profits are gushing, with no end in sight.

Oil service companies — supporting the hurricane recovery efforts, new exploration, pipeline construction and more — have an especially strong profit outlook.

What about the correction they’ve suffered in recent weeks? Unless something fundamental changes, you have to assume that it’s no different than the periodic corrections we’ve seen for the past three years.

For example, in the Oil Service HLDRS (OIH), representing a basket of large service companies, we saw similar corrections in May 2004 … August 2004 … October 2004 … and March-May 2005.

And despite all these corrections, we still have a 3-year uptrend that’s intact … plus a 6-month uptrend that’s also intact. If this changes, we’ll let you know. But until it does, you should hold your core positions in energy.

Meanwhile, nearly all natural resources — crude oil, natural gas and coal … copper, zinc and aluminum … tungsten and other minerals … are continuing to march higher.

And Canada, the nation in the forefront of this superboom, is giving birth to some of the great giants of tomorrow that can be bought today at a small fraction of their true value. (For all the details, see our latest report, “Canadian Natural Resources on Fire“.)

Personal Computers:
Sinking Further Despite
Strength in Tech Sector

The Nasdaq is suffering from its own, mini-version of market schizophrenia.

While the broad picture may look good on the surface, when you drill down to individual sectors, it can sometimes be downright ugly.

In recent issues, Tony Sagami has shown you why, and he will continue to provide ongoing updates regularly. For now, suffice it to say that he’s been right as rain about the personal computer sector, which he long ago picked out as one of the big losers to avoid.

Consider Dell, for example, until recently the centerpiece of Wall Street’s hopes for recovery in the tech sector.

Since the middle of August, the stock has plunged virtually nonstop. Even since mid-October, while the Nasdaq has been going up, Dell’s plunge continues unabated.

A short-term rally is possible at almost any time. But if it happens and you still own Dell or other PC companies, it should be a good chance for you to get out.

General Motors:
Bankruptcy Looms

When I first warned that General Motors was on a collision course with bankruptcy, most analysts scoffed.

If a company that large goes under, they argued, it would be a disaster. Hundreds of thousands would lose their jobs, they said. Other, related and unrelated industries would get killed. Obviously, they concluded, that cannot happen.

That’s also what Kirk Kerkorian thought when he poured money into the company this past spring.

But now look! Bankruptcy is now being discussed more widely, and GM’s shares have plunged to brand new lows, wiping out the so-called “Kerkorian rally.”

New, old woes: The company has just admitted that it overstated its 2001 earnings by a whopping $300 – $400 million.

If we were talking about less than 10% of earnings, it might not be so bad in the overall scheme of things. But this accounting distortion could be as much as thirty-five percent of GM’s total profits for that year.

Likewise, if there were some assurance that this is the last in a string of accounting issues to be come to light, investors might breathe a sign of relief.

But, that is also not the case. The SEC’s investigation of GM, as well as the company’s internal inquiry, are bound to turn up a lot more.

Meanwhile GM has announced still another discount-pricing incentive campaign, just the most recent in a long line of failed sales campaigns.

Your Actions

Overall, these are not exactly the ingredients of a healthy economy or a long-term bull market.

So despite any near-term strength in the broad averages, never forget that this is a schizophrenic market.

And in this kind of market, you need to be very selective — avoiding sectors that are fundamentally weak (such as banks, personal computers and autos), while sticking with those that are fundamentally strong (such as energy).

The best stock-selection tools, in my view, are the stock ratings produced by our affiliate, Weiss Ratings. They may not always be in agreement with our personal views about an individual stock. But their accuracy has been largely unbeatable, as attested to their first place ranking in the Wall Street Journal in June. (Based on third-party data from Investars.com.)

For up to three free Weiss ratings on your stocks, provided instantly online and updated via e-mail alerts, go to www.WeissWatchdog.com.

Good luck and God bless!

Martin

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