Caution last week crept back into investors’ vocabulary for the first time in more than three months as they faced up to President Barack Obama’s plan to reform the US financial market regulations, weighed the prospects of a global economic recovery and whether the “green shoots” needed more monetary water, and also started pondering the second-quarter earnings season.

As risk-taking moderated, profit-taking on equities and commodities set in after a colossal advance since early March. Government bonds rallied further, high-yield corporate bonds met selling pressure, spreads on credit derivative indices widened, and the US dollar marked time. “We could be seeing one of those occasional ‘all-change signals’ in short-term trends,” said Fullermoney editor David Fuller from across the pond.

From his new abode at Gluskin Sheff & Associates, David Rosenberg said: “Post-credit collapse and asset deflation cycles are always gripped with fragility; the intermittent beta trades and flashy rallies only serve to tell us that nothing moves in a straight line. In the meantime, the incoming data do suggest that recession pressures are subsiding, but it is difficult to see what the sources of recovery are going to be outside of government spending.”

Source: Gary Varvel

The week’s performance of the major asset classes is summarized by the chart below. Not shown, the entire precious metals complex was again out of favor with investors, with gold bullion’s (-0.5%) high-beta cousins - platinum (-3.7%) and silver (-4.1%) - being sold off by cautious investors.

Source: StockCharts.com

The US dollar ended the week virtually unchanged after Russian President Dmitry Medvedev told a regional summit on Tuesday that new reserve currencies, in addition to the dollar, were needed to stabilize the global financial situation. Meanwhile Brazil, Russia, India and China went on the biggest dollar-buying binge in eight months during May, adding $60 billion to their reserves, as cited by MoneyNews (via Bloomberg).

Many stock markets on Monday registered their worst single-session losses in a month. Mature markets perked up towards the end of the week, but emerging markets, in a number of instances, were down for all five trading days. After a four-week winning streak, the MSCI World Index (-3.0%) and the MSCI Emerging Markets Index (-5.0%) closed the week at their lowest levels since the last week of May.

Facing lackluster volume, the major US indices all ended the week in the red, but less so than most European and emerging bourses, as seen from the movements of the indices: S&P 500 Index (-2.6%, YTD +2.0%), Dow Jones Industrial Index (-2.9%, YTD -2.7%), Nasdaq Composite Index (-1.7%, YTD +15.9%) and Russell 2000 Index (-2.7%, YTD +2.7%).

To put the decline in context, the biggest pullback in the S&P 500 since the March 9 low happened in late March when the Index dropped by 5.9% over the course of two days. The most recent decline took the Index down by 5.0% between May 8-15. The S&P 500 is currently a more modest 2.7% off its high of June 12.

After climbing into the black for the year to date in the prior week, the Dow fell back to -2.7% last week - the only major US index in the red for 2009 - and, along with the FTSE 100 Index (-2.0%), one of the few global indices in this unenviable position.

Click here or on the table below for a larger image.

As far as non-US markets are concerned, returns ranged from top performers - mostly African countries - Sri Lanka (+10.7%), Kenya (+9.5%), Namibia (+8.5%), Uganda (+7.3) and Côte d’Ivoire (+5.0%), to Russia (-9.8%), Qatar (-9.8%), Argentina (-8.4%), Ukraine (-6.9%) and Finland (-6.8%), which experienced headwinds.

In a bullish move, the Shanghai Composite Index - one of the leading markets in the advance over the last few months - bucked the downtrend with a gain of 5.0%. However, the Russian Trading System Index - the top-performer for the year to date (+70.7%) and since the November 20 lows (+104.8%), succumbed to profit-taking, losing 9.8% on the week. Also, the Bombay Sensex 30 Index (-4.7%) declined after rising for 14 consecutive weeks. (Click here to access a complete list of global stock market movements, as supplied by Emerginvest.)

John Nyaradi (Wall Street Sector Selector) reports that as far as exchange-traded funds (ETFs) are concerned, the leaders for the week included offshore “short” funds such as ProShares Short MSCI Emerging Markets (EUM) (+7.4%) and ProShares Short MSCI EAFE (Europe, Australia, Far East) (EFZ) (+3.3%). On the other side of the performance spectrum, losers centered in the energy sector, including Market Vectors Coal (KOL) (-13.4%) and iShares Dow Jones US Oil Equipment & Services (IEZ) (-11.6%).

In a white paper released on Tuesday night, the Obama administration detailed a number of proposals to overhaul the US system of financial regulations in an effort to restrain the reckless risk-taking that triggered the economic crisis.

The quote du jour this week is related to this regulatory reform and comes from Barry Ritholtz, editor of The Big Picture blog and author of Bailout Nation, a newly published and must-read book, who remarked: “The Federal Reserve, despite its role in causing the crisis, gets MORE authority. Under Greenspan, the Fed did a terrible job of overseeing banking, maintaining lending standards, etc. Why they should be rewarded for this failure with more responsibility is hard to fathom. It is yet another example of rewarding the incompetent.”

Ritholtz offers a better solution: “Have the Fed set monetary policy. They should provide advice to someone else - like the FDIC (Federal Deposit Insurance Corporation) - who hasn’t shown gross incompetence.”

Other news is that the US Treasury is planning to revamp securitization with new rules designed to reduce the incentive for lenders to originate bad loans and flip them on to investors. The aim is to restore confidence in and revitalize securitized markets, which financed more than half of all credit in the US in the years immediately prior to the credit crisis.

Next, a quick textual analysis of my week’s reading. No surprises here, with all the usual suspects such as “market”, “financial”, “credit”, “economy”, “stock”, “banks” and “China” featuring prominently.

Back to the stock markets: an analysis of the moving averages of the major US indices shows the S&P 500, the Nasdaq Composite and the Russell 2000 trading above their 50- and 200-day moving averages, albeit marginally so in the case of the S&P 500. On the other hand, the Dow Industrial and Dow Transportation are below the key 200-day line, but still a few points above the 50-day average. Only the Nasdaq Composite trades above its January peak. The levels from where the rally commenced on March 9 should hold in order for base formations to remain in force.

Click here or on the table below for a larger image.

Not only are the indices very close to important moving average support levels, but a short-term oscillator such as the rate-of-change (momentum) indicator is on the verge of giving a selling signal, i.e. crossing through the zero line in the bottom section of the S&P 500 chart below. Also note the negative divergence between the Index and the ROC line - typically a warning sign that a near-term trend change will take place.

Source: StockCharts.com

The Bullish Percent Index shows the percentage of stocks that are currently in bullish mode as a result of point-and-figure buy signals. With the figure at 64.8%, this indicator conveys the message that the majority of stocks are in uptrends, but the line has turned down and the chart has the appearance of at least a short-term top.

Source: StockCharts.com

Richard Russell, veteran writer of the daily Dow Theory Letters, commented on Monday: “I’m of the opinion that this bear market rally is in the process of topping out. When a counter-trend rally tops out within an ongoing primary bear market, the odds are that the stock market will break to new lows during the period ahead. That means that the stock market will break below its March 9 lows in coming weeks. A violation of the March 9 lows would be a shocker to most investors, and it would be a forecast of an even worse economy coming up.”

For more about key levels and the most likely short-term direction of the S&P 500, Adam Hewison of INO.com prepared another of his popular technical analyses. Click here to access the short presentation. (The analysis was done on Tuesday, but is still as relevant today as it was a few days ago.)

Turning to equity valuation levels, economist and strategist David Rosenberg, said: “The notion that we had moved to Armageddon lows in equities does not seem to hold water. After all, the forward P/E multiple on the S&P 500 at the lows was 11.7x. That was not a multi-decade low or some massive standard-deviation figure - we were actually lower than that at the October 1990 lows when the multiple was 10.5x and frankly, coming off the 1987 collapse, the forward P/E had compressed to 9.8x.

“As it now stands, the multiple is back very close to where it was at the October 2007 market high when the multiple had expanded to 15.0x. The range on the forward P/E over the last quarter-century is between 9.8x and 21.8x (excluding the tech bubble), so at 14.5x currently, it is hardly the case that this market can be viewed as a bargain. On a trailing earnings basis, the P/E multiple has actually widened, from 17.0x at the lows to 23.3x currently, a huge multiple expansion.”

Nouriel Roubini, professor at NYU’s Stern School and Chairman of RGE Monitor, shares the view that the stock market rally is long in the tooth. According to Yahoo, Tech Ticker, he pointed to three factors that would lead to a correction in the near future: (1) Volatility and uncertainty would increase; (2) Corporate earnings would disappoint; and (3) The global financial system still faced serious problems.However, Roubini was not convinced that the market would retest the rally lows.

Taking an opposite stance, Mario Gabelli, chief investment officer at Gamco Investors, sees rosy times ahead for the economy and stock market, as reported by MoneyNews. He noted that the Dow Jones Industrial Average was now at 8,500. “Twelve years ago it was 8,500 … In 10 years, 8,500 will look like a bargain, and it’s a bargain today. The best way to make money in the coming bull market is ‘plain old stock picking’,” said Gabelli.

In my opinion, it seems as if the spring rally has probably exhausted itself. It is difficult to envisage how much of a pullback we might see, but I maintain that it will still be part of a bottoming process. I would nevertheless assume a defensive position, as a bigger and longer correction than what many pundits are expecting cannot be excluded.

For more discussion on the direction of stock markets, also see my recent posts “Gold, gold, you’re making me old“, “Albert Edwards: Expect new equity lows in H2, China is global Achilles’ heel“, “Video-o-rama: Regulatory reform dominates debate“, “Stock markets: retreat in store?“, “The recession in historical context“, “Technical talk: S&P 500 turning down from 950 again” and “Have stock markets run away from reality?“. (And do make a point of listening to Donald Coxe’s webcast of June 19, which can be accessed from the sidebar of the Investment Postcards site.)

Economy
“Global business sentiment is much improved during the past three months. Most notable is the optimism regarding the economic outlook toward the end of this year. Assessments of current business conditions and the strength of sales have also measurably improved,” said the latest Survey of Business Confidence of the World conducted by Moody’s Economy.com. However, confidence is still weak and fragile, consistent with an ongoing global recession.

Although the European Central Bank (ECB) has warned that Eurozone banks face additional losses of more than $283 billion this year and next, German investor confidence, as measured by the ZEW Economic Sentiment Index, rose to a three-year high in June. The improvement suggests that investors are more confident that the worst of the financial crisis and recession has passed. However, the ZEW Current Situation Index remained around its six-year low in June, indicating that the German economy remains in recession.

Source: ZEW

“‘Green shoots’ is no longer the favorite phrase among policymakers. During last weekend’s meeting of Group of Eight (G8) finance ministers, the message shifted to emphasize that it was far too early to sound the all-clear for the world economy,” writes the Financial Times.

“I don’t think we’re at a point yet where we can say we have a recovery in place,” said Tim Geithner, US Treasury secretary, and continued this theme a day later by saying “it is early still” and “we have a way to go”. Britain’s finance minister, Alistair Darling, said “we’re not there yet”, and the IMF’s Dominique Strauss-Kahn said “the recovery is weak”.

Focusing on the country that seems to have cruised best through the economic malaise, the World Bank raised its forecast for China’s 2009 gross domestic product growth to 7.2% (from 6.5% three months ago), saying the apparent success of the government’s stimulus package had improved the outlook from March, as reported by the Financial Times. The bank estimates a full six percentage points of this year’s 7.2% GDP growth will come from investment and spending either carried out by the government or directly influenced by it.

According to US Global Funds, another validation of China’s economic recovery is provided by the recent growth in government revenue, thanks to rising business tax receipts. “Going forward, a virtuous cycle may set in when improving private sector activity encourages corporate expansion, which in turn benefits employment, income growth, and consumption.”

Source: US Global Funds - Weekly Investor Alert, June 19, 2009.

However, Albert Edwards, global strategist at Société Générale, said (via the Financial Times): “I believe the bullish group-think on China is just as vulnerable to massive disappointment as any other extreme or bubble nonsense I have seen over the last two decades. The fall to earth will be equally as shocking.”

In the world’s second largest economy, the Bank of Japan opted not to make any changes to its monetary policy, stating that economic conditions in Japan “have begun to stop worsening”.

A snapshot of the week’s US economic data is provided below. (Click on the dates to see Northern Trust’s assessment of the various data releases.)

June 19
• June 23-24 FOMC meeting - coast is not clear yet, minor modifications of April statement likely

June 18
• Index of Leading Indicators suggests worst is over
• Continuing Claims post large decline
• Philadelphia Fed Survey points to improving factory conditions

June 17
• Subdued inflation data leave room for Fed
• Significant improvement in current account deficit

June 16
• Housing Starts - turning the corner?
• Factory Production and Operating Rate remain problematic
• Higher prices for energy and tobacco lift overall Wholesale Price Index

Also, Reuters reported that US credit card defaults rose to record highs in May, soaring to 12.5% from 10.5% in April in the case of Bank of America. This is yet another sign that consumers remain under severe stress.

Summarizing the outlook for the US economy, Asha Bangalore (Northern Trust) said: “For all purposes, although the nature of incoming economic data and current financial market conditions indicate that the worst is behind us, real GDP in the second quarter is projected to decline again. The headline reading of real GDP should show a noticeably smaller drop in the second quarter compared with the 5.7% drop in the first quarter.

“There is mixed opinion in the marketplace about the third-quarter performance of the economy. We expect the economy to gather steam only by the final three months of 2009. The FOMC’s projections show a decline of real GDP growth (Q4-to-Q4 basis) in 2009 to range between -2.0% and -1.3%. The bottom line is that the Federal funds rate will hold unchanged for several months ahead.”

Week’s economic reports

Source: Yahoo Finance, June 19, 2009.

In addition to an interest rate announcement by the Federal Open Market Committee (FOMC) (Wednesday, June 24), the US economic highlights for the week include the following:

Source: Northern Trust

Click here for a summary of Wachovia’s weekly economic and financial commentary.

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global financial markets performed during the past week.

Source: Wall Street Journal Online, June 19, 2009.

“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity. Both bring a permanent ruin. But both are the refuge of political and economic opportunists,” said Ernest Hemingway.

In these troubled times, let’s hope the news items and quotes from market commentators included in the “Words from the Wise” review will help Investment Postcards readers to spot the opportunities and invest wisely.

Click here for some more thought-provoking news items and quotes from market commentators.

For short comments - maximum 140 characters - on topical economic and market issues, web links and graphs, you can also follow me on Twitter by clicking here.

Happy Father’s Day to all, and enjoy the longest summer’s day of the year (in the northern hemisphere)!

That’s the way it looks from Cape Town as May draws to a close.

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Buffoonish fathers

Source: David Fitzsimmons

* Dr Prieur du Plessis is chairman of Plexus Asset Management and writes the Investment Postcards from Cape Town blog (www.investmentpostcards.com)