INSIGHTS

On August 09, 2011

Capitulation Could Usher in Fresh Buying Opportunity

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Peroni Report – August 2011 (DJIA: 10,809.85)

Until just the last several weeks, the stock market has amazed with its thick-skinned behavior and tenacious uptrend amid a relentless parade of adverse headline news. Perhaps the stock market finally succumbed to emotional fatigue with investors throwing in the towel and selling indiscriminately in August 4th’s session. This decline, which had the earmarks of capitulation, came after a lengthy daily losing streak. Until that sharp selloff, the CBOE Volatility Index (VIX) had been poker-faced revealing little fear as it held in a relatively tight trading range. But the August 4th session shook psychology, pitching the market lower. After a nice rebound in the following session, Standard & Poor’s finally did what many observers had long expected by lowering its rating on U.S. debt. The announcement, while no real surprise, may have been awkwardly timed since it came after a rough and tumble week in the stock market and at the start of a weekend where it had time to fester before Monday’s opening.

What concerns me is that the stock market fell seemingly based on news items or anticipated events that had been on the table for some time; at least long enough for the market to ponder and digest. What concerns me is that the financial markets may be bracing for something that is not as yet out in the open. The financial sector and, in particular the big banks, have been underperforming this year. I am observing technically ominous chart patterns in several of the major institutions, leaving me to wonder if there might be one more shoe to drop before the market can finally probe for and lay claim to a bottom.

August 4th’s broad selling may have acted as a pause with Friday’s buying reducing the oversold condition. I expect the market could produce another event-driven down leg that drives the Dow Jones Industrial Average (DJA) to the mid/upper 10,000 area before a reversal gets underway. Therefore, while the selling may be reaching an extreme, it may not be fully played out with the Standard and Poor’s downgrading event alone. I believe the risk/reward ratio may be enticing in the upper DJIA 10K area but the technicals point to a prudent strategy of waiting to see if another selling trigger comes along.

The stock market will eventually calm and stabilize as crescendo fear levels subside. This should then allow a resumed focus on the two most important factors for the market historically – interest rates and earnings. Interest rates remain at very low levels and the Fed has said repeatedly it does not expect to tighten credit for the foreseeable future. Earnings have continued to surprise on the upside versus analysts’ expectations especially in many of the sectors that have led the market higher since the bottom in late 2008 to early 2009. Both of these factors are bullishly aligned and present a formidable case for the longer-term. Low interest rates and good earnings growth trends could make equity investments particularly appealing once a bottom is struck. The surge in the VIX is an encouraging sign that bullish sentiment has been substantially dampened. From a contrarian standpoint, this may set the stage for a potential springboard rebound from depressed levels as valuations are driven to recession-like levels.

The market is fast moving and some of this commentary could become outdated within a short period of time. That said, I offer this insight: I suspect this decline will not cause a major change in leadership. The best buying opportunities are likely to be in those stocks and sectors that were leading the market higher before the downturn. I continue to believe this will be an earnings growth focused market and, therefore, investors should choose equities that have produced the best earnings relative to Street expectations over multiple quarters. Several sectors that standout include: aerospace, agriculture, industrial, information technology and oil service.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog. For additional commentary or financial resources, please visit www.aamlive.com.