The Week Ahead, Jan 24 -28:

The week ahead is setting up to be an eventful one, as we will get data on housing and durable goods, and there will no doubt be more discussion coming out of the eurozone, all in the context of financial markets that are showing signs of a turn. Let’s get to the details.

Week in Review

Stocks: The market was speaking to us last week, and it was telling us to be cautious in several ways. One was the performance differential between the largest stocks and their smaller counterparts:

Another was the difference, with the S&P 500, between defensive and cyclical sectors:

Still another is the performance of a market leader:

The noise: the Dow was up for the week, extending it’s winning streak, and former market darling GE gained 5% on a strong earnings report. The signal: market internals are deteriorating appreciably.

Bonds: There wasn’t a great deal of noteworthy action in the bond market aside from a modest relief rally in the ongoing muni bond rout. Yield on the benchmark 10 year Treasury rose 2.5% for the week to finish just above 3.4%. Sovereign eurozone bonds gained on talk of monetization by the Financial Stability Fund in attempt to cap yields, though it wasn’t clear whence the money would come.

Commodities: If we were simply to look at the weekly change in the CRB index, we might think nothing happened; however, as usual in the commodity space, beneath the calm surface was much movement:

The big winner was the March natural gas future contract, up over 5% and extending what looks like a rally…more on this below.

Currencies: The US Dollar was off 1%, euro up 2%, the other major currencies up ordown fractionally. Apparently the market was buying what the eurozone policy makers were selling. Hmm…

The Week Ahead

Stocks: While all the major indexes are above their primary moving averages there has been, as we noted, marked deterioration in the internals. Tuesday we saw a surge in volume with little price advance followed by a couple of days of selling and a failed rally attempt on Friday. Foreign stocks have also been selling off, notably including the relatively strong Korean market. This suggests to me that the risk/reward picture for the coming week is tilted toward the risk side, so I have further reduced long positions and raised more cash.

Bonds: The interesting sector, to me at least, is the municipals. We have seen a pretty drastic selloff fueled by concerns about the condition of state and local government finances, the end of the Build America program, and Republican efforts to introduce state bankruptcy legislation. Last week the munis had a bounce that looked similar to previous failed rally attempts in mid November and mid December.

Will the third time be the bottom? It’s too early to tell, but note the technical divergence on the chart below: the rate of change and money flow into the iShares national muni fund (MUB) have been improving even as the price has continued to trend down. Yields in this bond sector are more attractive than any other; investors just need to understand the risk. In the interest of full disclosure, I hold open and closed end muni funds in taxable accounts, but do not hold MUB.

Commodities: There are a number of different things going on here. Precious metals, though they do have their intrinsic fundamentals, had been rallying on fiscal and monetary stability concerns. That rally appears to be slowing, with selling pressure on volume. Oil had gotten ahead of the supply fundamentals, and seems unable to hold a price above $90. Agricultural commodities on the other hand are rallying in line with their fundamentals, and this rally appears more durable. In particular, I think there may be opportunity in livestock futures, as the spread between corn and the live cattle and lean hogs is unusually wide.

Another area I find interesting is natural gas, which has been a late participant in the energy rally. It’s a commodity that has given me good gains in the past, but I’m hesitant to jump in here, as the inability of oil to hold 90 suggests there isn’t strong across the board price pressure in energy.

Currencies: There isn’t much new to say here; the activity remains largely driven by political moves. I simply am a euro skeptic, so you know where my bias lies, because I still don’t see how they are going to make the numbers work. If I were trading this, which I’m not, my strategy would be to sell euro rallies and buy Dollar pullbacks. There are easier ways to make money.

Summary

As stated above, I don’t care for the risk/reward or the internal rotation, and have been trimming long stock positions for several weeks now in anticipation of a correction. However there is no reason to think it will be anything more than a garden variety and perhaps overdue adjustment. My outlook for precious metals is similar. Bullish on agriculture. Neutral on oil and natural gas as well as bonds, where I would be looking for yields to fail at recent highs before buying.

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