Surveying a Troubled Playing Field
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"Well, ya got trouble, my friend. Right here, I say trouble right here in River City. With a capital 'T' and that rhymes with 'B' and that stands for..."
--
The Music Man
That "B" might stand for "bonds." The 10-year bond has ticked up a quarter-point this week, which helped spook a market that has already been grappling with higher commodity prices, especially oil. Higher interest rates are a natural consequence of an improving economy, and the stock market anticipates them to some degree. However, interest rates also rise because of inflationary pressures, which are a major negative for the stock market because it means costs are going up for many companies without a similar increase in sales or profits.
Increases in oil prices are a particularly good example of how inflation is a negative for the market. Higher oil is great for oil companies, but for any business that uses oil, it simply increases the cost of doing business and squeezes margins. When inflationary pressures affect other basic materials, the stock market must start pricing in the impact that will take on profits.
If the economy was hot, companies would be able to raise prices and keep their margins intact. But although our economy is improving, it's just plodding along at a slow and steady pace. Most companies do not have the ability to pass along higher prices to their customers, so profits are squeezed, P/Es contract and stock prices fall.
Higher oil, higher interest rates and a weak dollar in a so-so economic environment amount to a very troublesome combination for stocks. We have to stay defensive when trouble of this type is brewing. If the trend continues to build, we will see much lower equity prices.
One positive development we need to watch for is a rotation into technology stocks, particularly semiconductors, which I have been yapping about. Technology is less affected by inflationary pressures in basic commodities, so it's often the beneficiary of investors looking for a place to put some cash.
The rotation theme makes sense as money comes out of groups such as steel, oil and deep cyclicals, but the big problem is whether the fundamentals are strong enough to attract the bulls. The valuations of many technology stocks, particularly the bigger-cap tech stocks, are not compelling to value-oriented buyers.
Intel
(INTC) - Get Report
has its midquarter update tonight, which will be very important in determining whether a technology rotation can gain some momentum. The conditions are ripe for technology to show relative strength, but some good news is needed to light the fire. Even if technology stocks do begin to show relative strength, that doesn't necessarily mean they will move up strongly. They simply may not go down as quickly as the rest of the market does.
We have some major worries right now and capital preservation should be your priority until conditions improve.
James "Rev Shark" De Porre is a self-taught trader who primarily trades for his own account from his home on Anna Maria Island, Fla. He is a member of the Michigan Bar Association and a former tax attorney and CPA. De Porre holds business and law degrees from the University of Michigan. He was formerly the host of America Online's The Shark Attack and presently operates SuperTraders.com. At the time of publication, he did not have any positions in any of the stocks mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback and invites you to send your comments to
RevShark@aol.com.