Fourth Quarter Off To A Rough Start

After posting impressive returns of over 15% in the third quarter, the major stock indexes started the final quarter of 2009 with large losses. The S&P 500 closed down 2.6% while the Nasdaq lost just over 3%. The downside bias was set early this morning as weekly jobless claims data showed an unexpected deterioration, and selling gathered steam following the release of September ISM Manufacturing data which showed a slight decline from August activity. The selling was widespread as declining stocks outnumbered advancing issues by a 17 to one margin. Tomorrow's payroll employment report looms large, as many are now calling for worse than expected job losses in light of disappointing jobless claims.

Perhaps today's selling is just a brief pause in the nearly seven month long bull market advance. We have witnessed several shallow pullbacks over the summer that were soon followed by aggressive buying and new market highs. In the bullish camp, we would point to steadily improving economic data as well as "performance anxiety" of fund managers that have missed the rally (those would not include funds in Kanaly's equity portfolio, the average of which are up nearly 30% year-to-date). Bearish investors, including ourselves, insist that the financial and economic crisis has only been temporarily masked by inventory restocking, cash for clunkers, and massive government printing of money. With third quarter earnings reports just around the quarter (Alcoa kicks it off next Tuesday), investors will be looking for significant improvement to justify current lofty valuations.

We have our eye on a handul of recent market developments that could offer clues for the near term direction of stocks:

• First, we are watching the credit markets. A strong rally in corporate credit has lent credibility to the stock market advance. Today, however, high yield debt lost almost 3%, while Treasury bonds enjoyed strong upside to drive yields to the lowest level in months (10-year Treasury at 3.18%, and the 30-year Treasury broke below 4%) . This is an indication that investors are reducing their appetite for risk.
• The U.S. Dollar, despite loud predictions of a coming collapse, has quietly strengthened recently and may be forming a near term bottom. Significant dollar appreciation from here threatens the commodity rally and likely causes a correction in stocks.
• The Volatility Index (VIX) soared 10% today, indicating increased investor fear.
• For the first time in months, it appears the S&P 500 Index may be tracing out a lower high. After closing at a 2009 high of 1071 on September 22, the index touched 1080 the next day but then sharply reversed lower to close at 1060. Subsequent rally attempts have failed to set a new high, suggesting at least a pause in the bull market.