Just When TheySaid It Was Safe

The media think the market is out of its doldrums, thanks to a surge upward last week. Don’t let that sucker you in. As I’ve said from the beginning of the year, this is a time for saving money and picking what you want to own, then waiting to pounce on it at a cheap price.

Last week didn’t deliver cheap prices; it delivered expensive ones. The watch word is still patience. Let’s take a look back to help us plan ahead.

Weak inflation data launched the market higher last week:

Dow +2.6%
Nasdaq +5.2%
Nasdaq 100 +6.0%
S&P; 500 +2.8%
S&P; Midcap 400 +3.6%
S&P; Smallcap 600 +4.0%

The Israel-Hezbollah cease-fire and lower oil prices kicked off a morning rally in stocks on Monday. Alaska’s Prudhoe Bay oil field, thought to be out of service for a while due to leaky pipes, looked set to produce more than expected. That, too, lifted the mood for stocks.

Then, everything reversed. The cease-fire looked wobbly as fighting continued in areas. That caused oil to pare its losses. As oil prices rose again, investors thought about the next day’s PPI data and Wednesday’s CPI data and decided to hold off on buying too much. With so much depending on those inflation numbers, and the numbers being so uncertain, a wait-and-see attitude prevailed. For the day, the Dow gained just 0.1% and the Nasdaq just 0.6%.

When the producer price index came in much lower than feared on Tuesday, out came the party streamers. The PPI increased only 0.1% in July against expectations of a 0.4% jump. The core rate fell 0.3% against expectations of a 0.2% gain. This is the first time since last October that the core PPI has posted a decline.

That’s good news to stock investors because it means inflation pressures are lower than thought. Less inflation means less chance of another interest rate increase from the Fed. This sentiment stands in stark contrast to the prior week’s assumption of more increases ahead, highlighting just how whimsical are the forecasts of economists and stock pundits alike. Prior to the data, the futures market gave a 42% chance of another rate hike. Following the release, it fell to just 30%.

The buying frenzy steered most investors toward technology as it’s the year’s most depressed sector so far. Agilent Technologies (A) gained 9%, Computer Associates (CA) gained 7%, Dell (DELL) gained 4%, and Yahoo (YHOO) gained 3%.

For the day the Dow gained 1.2% and the Nasdaq gained 2.2%.

Wednesday extended the mood with the second part of last week’s one-two punch combo to knock out inflation. The core consumer price index increased only 0.2% in July against expectations of a 0.3% gain. The lower reading broke a four-month string of 0.3% gains, lending credibility to the Fed’s soft-landing scenario. Indeed, futures gave only a 20% chance of another rate hike next month from the Fed.

Then, separate data showed that the housing market is definitely slowing down. July housing starts dropped 2.5% and building permits dropped 6.5%. The numbers are down 13% and 21% respectively from a year ago. That’s further evidence that higher rates have already put the brakes on the economy. So, there’s no need to push harder on the pedal by raising rates even further.

Something the market overlooked last week was that while the short-term news is good for rates, the long-term trend is still too hot for the Fed’s liking. The year-over-year increase in the core CPI is 2.7%, far over the 2% ceiling of the Fed’s target range. There’s still August’s data to consider as well when it’s reported next month. While the knee-jerk reaction was that rate hikes are behind us, it’s nowhere near as certain as last week’s bash would have us believe.

Also, there’s the issue of what a slowing economy means beyond the end of rate hikes. Stable interest rates are great, but they’re only going to come when there’s enough evidence to believe that the economy has slowed sufficiently. Some day, investors will notice that a slower economy lowers company earnings. That’s not good for stocks.

That realization was nowhere in sight last week, though, and the market partied on. Another drop in oil prices provided further encouragement. Investors flocked to technology again, sending the PHLX Semiconductor Sector index up 4.3% and Hewlett-Packard (HPQ) to an intraday 52-week high.

Just before the confetti was swept up, the Dow closed Wednesday 0.9% higher and the Nasdaq 2.3% higher.

Given the celebratory mood of Tuesday and Wednesday, it came as little surprise when Thursday settled into an unexciting gurgle along the unchanged mark. Oil fell for the fourth day in a row; all the way down to $70, the lowest price since June. The Israel-Hezbollah cease-fire looked to be holding up. Those two factors lent a slightly positive bias, and the Dow finished the day up 0.1% while the Nasdaq came in with a 0.4% gain.

Friday was similar to Thursday. Oil rose 1.5%, which helped energy companies but had little impact on the broader market. Technology continued to lead the way higher, this time helped by a 4.4% gain by Microsoft on news that it would complete less than one-quarter of its $20 billion stock buyback plan this week. The rest will be shifted to later quarters. That’s a nice ongoing source of support for the stock.

Shares of Altria (MO) rose 3.3% to an all-time high when a U.S. District Court judge imposed no financial penalties on the company for hiding the perils of smoking from an unsuspecting public.

The Dow finished Friday up 0.4% and the Nasdaq 0.3%.

Without a doubt, it was an impressive week for stocks. The key indices rose on all five days. It was the Dow’s best streak since May, the S&P; 500’s since March, and the Nasdaq’s since January. The Nasdaq gained more last week than in any other week of the past three years.

Does that strike you as a little too bright for what happened? It does me. What should have been received as mildly positive news was blown out of proportion, in my opinion. The market was oversold, due for a bounce, and seized on some good economic data to flex a lot.

Don’t lose perspective here. A mid-August rally is not unusual; nor is subsequent late-August weakness. Too, this was an options expiration week and followed the quick rally pattern seen during such weeks in June and July, both of which were followed by further weakness. Finally, the gains happened on low volume. I continue to urge caution and patience. The best time to buy prior to the year-end rally is probably yet to come.

Now, let’s sift through The Kelly Letter’s current holdings.

The good news, of course, is that the bulk of our money leverages the indices to the upside via our permanent portfolios. Among our individual holdings, most are in technology. Last week was very good to both components of what we hold.

So far this year, the Dow 1 is up 16%, Double The Dow is up 9%, and Maximum Midcap is down just 0.7%. A week ago, they checked in at +11%, +4%, and -7% respectively.

Our individual holdings performed even better. For last week:

Debt Collection +6%
Semiconductor Equipment +4%
Brewing +1%
Computers +5%
Media +2%
E-commerce +13%
Student Loans +12%
Semiconductors +6%
Computer Security +9%
Software +6%
Pharma +5%
Leveraged Short -11%
Online Media +8%

Which figure doesn’t belong with the rest? Look carefully. Indeed, my hedge against the market looked positively goofy last week.

As gratifying as the market surge was, I’m disappointed. I wrote several times before that I want lower prices in the short term because we’ll pounce on them and make more money later this year and early next.

Our e-commerce company’s recent three-week history provides a snapshot of what I was — and am still — hopi
ng to do with more of our positions. We first bought it on May 22 at $29. By the beginning of this month, it was down 21%. We doubled down on Aug. 2 at $23 to give us an average price per share of $25.65. A week ago, we were still down 6% on this holding. Now, we’re up 6%.

When the worm turns, it turns hard.

Doubling down on good companies is a surefire way to make money over time. I rely on this technique frequently, much to the dismay of several esteemed colleagues. Stop losses are the order of the day at most services. I use stop-losses now and then, as long-time readers know. More often, though, I look at short-term pain as the time to make long-term gain.

That’s why I was disappointed to see the rocket boosters fire so strongly last week. The short-term sale ended early before we could put more money to work.

For now, that is.

Have I changed my August/September outlook? Am I selling our hedge now because the rough times are behind us? Do I think we’ve seen the low for this year?

No, no, and no.

In brief, here’s why:

  • I think the market overreacted to the inflation data
  • It was tame, but it wasn’t that tame
  • We have another set of data before the next Fed meeting
  • A mid-August rally is not unusual
  • It’s usually followed by late-August weakness

Plus, last week was August’s options expiration week. The rally was consistent with the ones we saw during the expiration weeks of June 12 and July 17. In each case, the market fell again. I think that pattern will play out this time, too. I think the market will head lower before pulling back hard on the joystick and heading for the sky.

What we should take away from last week is a glimpse at the power behind the portfolio The Kelly Letter has spent the year building. When the market gets tired of going down and goes up again, it takes our holdings with it. Moreover, our holdings lead the market higher. We own great stuff, and we’re going to make a lot of money off of it when a sustained bull arrives.

Prior to that, though, hop on one foot around a fire and chant for the winds to whoosh downward again. Include in your chant these lines:

  • It’s the worst season for the stock market
  • It’s the worst season for hurricanes
  • It’s the worst time of the mid-year election cycle
  • The yield curve is inverted
  • Inverted yield curves often foreshadow recessions
  • The housing market is imploding
  • Long-term inflation rates are still too high
  • The economy is slowing down
  • Earnings will eventually slow down
  • The DETOnations of the Middle East control oil

At least one line from your chant will drift its way to Wall Street, sending the averages down before things get truly better and we embark on a sustained upward trajectory.

This week’s best negative commentary came courtesy of Lon Witter, writing in Barron’s:

By the release of the August housing numbers, it should become clear that the housing market is beginning a significant decline. When this realization hits home, investors will finally have to confront the fact that they are gambling on people who took out no-money-down, interest-only, adjustable-rate mortgages at the top of the market and the financial institutions that made those loans. The stock market should then begin a 25%-30% decline. If the market ignores the warning signs until fall, the decline could occur in a single week.

Would you like guidance through the perils ahead that should lead to a great buying opportunity? If so, come along with us at The Kelly Letter for a month to see if you like what we’re doing. If you do, stick around for more. If not, no problem, you can stop receiving the letter and never pay more than a cent.

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