Techs Fails to Endorse the Financials-Led Rally

A SPIRITED RALLY SNAPPED the stock market's six-week losing streak and lifted shares off their two-year lows. But just how decisive -- and lasting -- is this latest turn?

Quite unusually, the climax was spread over three days, with Monday's plunge followed by a tussle on Tuesday before the eventual lift-off on Wednesday. Trading was heavy -- New York Stock Exchange composite volume topped seven billion on two separate days -- and the bounce, when it did come, was unequivocal. The afterglow even lasted until the weekend, with the market clinging to most of its hard-won gains.

The Dow Jones Industrial Average ended the week up 396, or 3.6%, at 11,497; its 4.9% rise after Tuesday was its biggest three-day gain since March 2003. The Standard & Poor's 500 index rose 21, or 1.7%, to 1261 and is 19.5% off its October peak. The Nasdaq Composite Index added 44, or 2%, to 2283, while the Russell 2000 climbed 18, or 2.7%, to 693.

Judges scoring last week's action awarded bonus points to how financial stocks -- the rot at this bear market's core -- had led this advance. Wells Fargo (ticker: WFC) managed to raise dividends, JPMorgan Chase (JPM) managed to top estimates, and the $2.5 billion Citigroup (C) lost last quarter manages to be more meager than feared. As a result, there was little that was ambiguous about the Financial Select SPDR 's (XLF) 23% bounce off its mid-week low.

The scramble to cover shorts played a big part, after a too-convenient rule change promised to make it costlier for traders to bet aggressively against some financial stocks. The 150 stocks within the S&P 1500 with the heftiest short interest jumped 15% over two days, while those with the least short betting struggled to scratch out a 2% gain. Still, an uptick in interest rates added some ballast to bank stocks, and to the extent rates might rise enough to thwart commodities, could even spell further upside for the broad market.

Can financials survive the summer without wilting? It helps that investor expectations were almost nonexistent. Among companies that have reported earnings so far, only 49% of financial stocks have beaten estimates -- the worst among S&P sectors, says Bespoke Investment Group. But those beating estimates saw shares jump 10.1% in the ensuing sigh of relief, and even those missing their marks shimmied up an average 3%. Contrast that with the crowded shelter of consumer staples, where 71% of companies have so far beaten estimates only to see their shares pull back 4.7%.

The resounding rally might have reduced the likelihood of another immediate, nerve-fraying slide to fresh stock-market hell, but a retest of the 2008 low before Thanksgiving cannot be ruled out. "The market is still in a state of flux," says Peter Green, publisher of the GreenScreen markets overview. Last week's rally might have been more convincing, for instance, if financials' advance was corroborated by technology. Instead, Microsoft 's (MSFT) muted outlook and concerns over Google 's (GOOG) advertising growth added to investors' many qualms and suggested "the market may not be ready yet for a sustained move up," Green says.

Just as important: Stocks' rise was lubricated by oil's slide, as crude fell $16.20 or 11.2% to $129 a barrel -- its biggest weekly drop in dollar terms ever. The last time oil fell by 2% or more on three consecutive days from its year's highs was in September 2000, which marked the start of a rocky patch and a year-long decline. Says Jason Goepfert of sentimentrader.com: "I suspect a further drop in the commodity would help stocks more than hurt."

Materials is the only S&P sector besides energy to manage a first-half gain (although just barely). So what are the odds of a second-half encore?

Prices for raw industrial materials and metals have pulled back sharply as the global economy falters. But materials stocks have continued to outpace the S&P 500, chiefly as momentum traders cling to what had worked in this bewildering market.

Among the warning signs: reduced estimates from the likes of Alcoa (AA) and Dow Chemical (DOW). Profit margins in the sector have slid, falling almost 20% from their 2007 peak, according to Merrill Lynch. Cash as a percentage of total assets also has declined, from just above 7% to below 5%.

Materials stocks have historically been risk-averse, so their stubborn run may have "to do more with momentum trading strategies than underlying fundamentals," suggests Merrill sector strategist Brian Belski. Besides the peaking commodity cycle, Belski sees a daunting backdrop of "deteriorating pricing power" and "a U.S. dollar that has found its footing against other major currencies."

The expectations bar also is set high, with profits still projected to jump 12% in the third quarter and 36% over the fourth -- chiefly on easier comparisons, according to Thomson Reuters.

With global manufacturing slowing and construction growth halved from recent peaks, materials stocks aren't exactly cheap either. The group traditionally traded at a discount of 5% to 10%, but now commands a premium on profits that recently were 24% higher than mid-cycle levels, notes Morgan Stanley global equity strategist Abhijit Chakrabortti. "While materials may not appear mispriced on current earnings estimates, these earnings are significantly above trend, leaving little cushion for potential disappointment."

WHEN AN OIL STRONGHOLD LIKE TEXAS plans to invest $4.9 billion in wind-generated electricity, you know wind power is more than just hot air.

Last week's nod from the Texas Utility Commission is good news for Trinity Industries (TRN), which has a small unit making wind towers. Trinity also makes everything from railcars to barges, and fading railcar demand had sent shares down 27% over the past year.


Dow but Not Out: Buoyant bank stocks and lower oil helped the Dow to a 4.9% rise after Tuesday, its best three-day percentage gain since March 2003.
When the Dallas company reports earnings July 30, expect to hear about how surging raw materials and economic deceleration have affected margins. After all, the CEO of a rival company recently bemoaned how everything railcar-related -- from pricing to demand -- "stinks."

But Trinity's cyclical rail business is moderated by a growing leasing and management-services unit, and downside risk is offset by the wind boom. Trinity's wind-energy backlog had surged 128% to nearly $1.6 billion in the first quarter, and its valuation should continue to expand with that backlog.

At 35, shares trade at 10.8 times 2008 earnings and 1.6 times book value, compared with 12.1 times earnings and 4.1 times book for other machinery stocks -- chiefly as investors fret about slowing railcars. "We believe investors should focus on Trinity's diversification and wind-energy catalysts," notes KeyBanc analyst Steve Barger, who has a 48 price target on the stock.

Among the warning signs: reduced estimates from the likes of Alcoa (AA) and Dow Chemical (DOW). Profit margins in the sector have slid, falling almost 20% from their 2007 peak, according to Merrill Lynch. Cash as a percentage of total assets also has declined, from just above 7% to below 5%.

Materials stocks have historically been risk-averse, so their stubborn run may have "to do more with momentum trading strategies than underlying fundamentals," suggests Merrill sector strategist Brian Belski. Besides the peaking commodity cycle, Belski sees a daunting backdrop of "deteriorating pricing power" and "a U.S. dollar that has found its footing against other major currencies."

The expectations bar also is set high, with profits still projected to jump 12% in the third quarter and 36% over the fourth -- chiefly on easier comparisons, according to Thomson Reuters.

With global manufacturing slowing and construction growth halved from recent peaks, materials stocks aren't exactly cheap either. The group traditionally traded at a discount of 5% to 10%, but now commands a premium on profits that recently were 24% higher than mid-cycle levels, notes Morgan Stanley global equity strategist Abhijit Chakrabortti. "While materials may not appear mispriced on current earnings estimates, these earnings are significantly above trend, leaving little cushion for potential disappointment."

WHEN AN OIL STRONGHOLD LIKE TEXAS plans to invest $4.9 billion in wind-generated electricity, you know wind power is more than just hot air.

Last week's nod from the Texas Utility Commission is good news for Trinity Industries (TRN), which has a small unit making wind towers. Trinity also makes everything from railcars to barges, and fading railcar demand had sent shares down 27% over the past year.


Dow but Not Out: Buoyant bank stocks and lower oil helped the Dow to a 4.9% rise after Tuesday, its best three-day percentage gain since March 2003.
When the Dallas company reports earnings July 30, expect to hear about how surging raw materials and economic deceleration have affected margins. After all, the CEO of a rival company recently bemoaned how everything railcar-related -- from pricing to demand -- "stinks."

But Trinity's cyclical rail business is moderated by a growing leasing and management-services unit, and downside risk is offset by the wind boom. Trinity's wind-energy backlog had surged 128% to nearly $1.6 billion in the first quarter, and its valuation should continue to expand with that backlog.

At 35, shares trade at 10.8 times 2008 earnings and 1.6 times book value, compared with 12.1 times earnings and 4.1 times book for other machinery stocks -- chiefly as investors fret about slowing railcars. "We believe investors should focus on Trinity's diversification and wind-energy catalysts," notes KeyBanc analyst Steve Barger, who has a 48 price target on the stock.