The Bubble Finally Bursts

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Stocks continued to sag throughout this past week, with traders once again taking their cues from overseas. On Friday, speculation began heating up that Chinese officials will soon begin to raise interest rates, after the country reported on Thursday that inflation surged to its highest level in more than two years in the month of October. Additionally, news hit the Street that Beijing is attempting to limit foreign investment in commercial real estate. The prospect of slower growth out of this rapidly emerging economy pressured stocks and commodities lower, with many market watchers expecting the central bank to announce tightening measures as soon as this weekend. Meanwhile on our shores, it didn’t help to have tech titan Cisco Systems announce a tepid profit outlook with its forecast of lower revenue growth for all of fiscal 2011.  Its shares tumbled by over 17% just on that news alone.  A pullback had been expected for along time, so it was not all that alarming, but it was an eye opener to finally see stocks retreat for a change.

It was a dismal week to say the least as the Dow Jones Industrial Average closed out with a weekly loss of 2.2%, to a level of 11, 192.58.  The broader Standard & Poor’s 500 fell 2.17%, to 1,199.21, and the Nasdaq Composite gave up 2.36%, to 2,518.21.   The smaller-cap stocks as represented by the Russell 2000 also tanked on the week, as this venerable index of fast growing emerging growth companies gave up 2.35%.  When it was all said and done, we ended a five-week winning streak and stocks posted their biggest weekly drop in three months.  It’s the biggest weekly point and percentage drop for the major indexes since the week ended August 13, and leaves stocks with just a slight gain for the month of November. However, hope springs eternal in our minds and the thing to remember as long term investors is that we’ve seen this before, as we offer some chicken soup for the weary investor’s soul. Every few months we sell off due to concerns about China trying to slow its economy, and every time we’ve bounced back. No bull market since World War II has ever died before its second birthday, and this bodes very well for the bulls going into the next year.  The damage was not all that bad, though, as the major indices are still holding up solidly above most psychological and technical benchmarks.  Keep in mind that a 15% rise from late August is still pretty impressive, and any sort of pullback might have been long overdue.

In hindsight though, investors appear to be having some second thoughts about the Fed’s QE2 plan though, as everything that rose in anticipation of the asset-buying program — stocks, Treasury’s, the euro, oil, gold and a host of other commodities — retreated sharply this past week. In fact, it was the theme throughout the week.  Bond yields continued to climb this past week even as the Federal Reserve began its bond-buying program known as QE2.  In the Treasury market, the 10-year note’s yield rose to 2.776% from 2.538% a week earlier and a low of 2.332% on October 8.  Meanwhile, the 30-year bond yield rose to 4.27% Friday from 4.122%, in part because of weak demand at Wednesday’s auction of this issue.

Getting back to the overall equity markets, the big picture going forward is how the inflation/deflation drama ultimately plays out.  China might see inflation, but the U.S. government does not presently foresee such, at least in the near-term.  China says it might raise rates, but the U.S. remains hell-bent on near zero Fed Fund rates indefinitely.  Our QE2 is now in play, and a lot of foreign countries, which include China, hate it.  Tug-of-war policies are now firmly in place, and it is just a matter of how they play out from here.  September and October were both relatively calm months with respect to the markets, but now November and possibly December are showing signs of potential volatility, so stay tuned!

It’ll be another busy week for economic data coming up, as we’ll get regional manufacturing reports from the NY and Philly Feds; October retail sales; CPI, PPI; industrial production & capacity utilization; and housing starts.  As far as earnings go, several important retailers will report their tallies this week including; Nordstrom, Urban Outfitters, Lowes, Abercromie & Fitch, Williams-Sonoma, Dollar Tree, Dicks Sporting Goods, Home Depot, Target, Wal-mart Stores, PetSmart, Footlocker, Amercian Eagle Outfitter,Gap, Staples and Ross Stores.

In the category of ‘believe it or not,’ consider that General Motors is returning to the public stock market with a post-bankruptcy stock offering this Wednesday, as it is attempting to raise close to $13 billion. It seems like it was just yesterday that they and several other automotive companies had filed Chapter 11.

Sources:  Barron’s, The Wall Street Journal, CNN, The New York Times, The Financial Times, Bespoke Investment Group, Thomson Reuters

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