Stocks Await Triple Play

The rally will contend with bonds, oil and the onset of earnings.
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Which matters more to the stock market, oil or interest rates? The stock market wasn't quite sure Tuesday, as the major indices fought to end in the green as rates climbed and oil dropped.

And now that question will unfold beside another variable as earnings-season jitters intensify.

The bond market continued to sell off Tuesday, which drove yields up, as its bet on rate cuts and a hard landing in the economy get harder and harder to support. The price of oil, on the other hand, ended the day sharply down by 2.4% to close under $60 per barrel at $58.52.

The

Dow Jones Industrial Average

gained 0.1% to close at 11,867.17 -- another record high, while the

S&P 500

added 0.2% to close at 1353.35, and the

Nasdaq Composite

finished up 0.1% to close at 2315.43.

Alcoa

(AA) - Get Report

and

Genentech

(DNA)

kicked off earnings season after the closing bell. Alcoa came up a tad short on the bottom line, while Genentech beat expectations. But both of their shares responded by declining in after-hours trading.

"The market fought to do not much of anything," says Art Hogan, chief market strategist at Jefferies & Co. "Alcoa may have reported, but we'd like to hear from at least 100 S&P 500 companies before we make a decision."

What market watchers are waiting to decide is the direction of the market once earnings season gets underway. Will earnings surprise to the upside or provide the much-feared disappointments to take apart the late-summer rally?

John Roque, a technician at Natexis Bleichroeder, came to the conclusion that the market is strong. While the market is "overbought," writes Roque, such a condition can mean two things: that a correction is at hand, or that the market is very strong, he writes.

If the latter scenario is in play, minor pullbacks like during last Friday's session are the norm. But Roque says the pullback on Friday was on lighter volume than that of the recent up days, and that the number of new lows did not increase enough to reveal a top.

Mary Ann Bartels, chief market analyst at Merrill Lynch, writes that some sentiment indicators have reached bullish extremes, which does warn of a correction to come. Bartels has long held that the market would experience a harsh correction in the fall, only to turn back up for a strong year-end finish. Bartels says the markets could well test highs of 12,100 for the Dow, 1380 for the S&P 500, and 2375 for the Nasdaq, but that those levels are likely to be points of resistance.

"We have viewed the post-July rally as an opportunity to increase defensive positions because we believe that the DJIA and S&P 500 are at risk of a 15% to 20% correction (30% for the Nasdaq)," she writes. "That is still the case."

If the answer is in the economic outlook, the soft-landing scenario is coming into sharper focus with more players taking a stance on its possibility.

To wit, a JPMorgan analyst put out a controversial report Tuesday upgrading the homebuilder stocks. Also, Moody's Investors Service noted that the default rate reached a new low of 1.9% for the month of September. Defaults typically increase when the economy slows and the

Fed

reaches a top in its tightening cycle.

The homebuilders fared well in Tuesday's trade on the upgrades. The

Philadelphia Housing Sector Index

gained 2.03% on the day. JPMorgan upgraded

DR Horton

(DHI) - Get Report

and

Standard Pacific

(SPF)

to overweight, sending their shares up about 4%, and increased

Toll Brothers'

(TOL) - Get Report

to neutral from underweight. Its shares gained 5.14%.

Also supporting consumers and the soft-landing scenario was the price of oil Tuesday, which fell as the energy-sensitive areas of the market performed well. The Dow Jones Transportation Index gained 1.3% on the day, and airlines such as

Continental

(CAL) - Get Report

added over 3%.

The bond market, which had been ignoring the mounting evidence that rate cuts are unlikely, took a bit of a beating Tuesday, as the stock market's optimism seems to be winning over bond traders. The bond market also may be paying greater heed to the recent spate of Fed-speak which has left bond investors somewhat rudderless of late, says T.J. Marta, chief fixed-income strategist at RBC Capital Markets.

On Tuesday, Dallas Fed President Richard Fisher said he's "comfortable" with the current fed funds rate, but is uncomfortable with inflation levels. He noted that "the current rate of inflation is too high," and that if inflation doesn't decline, the Fed will "take appropriate measures."

San Francisco Federal Reserve President Janet Yellen said Monday that she feels inflation may move down, but that current monetary policy is enough.

The fed funds futures market agrees, regarding the likelihood of rate cuts, at least. The odds of a rate cut have been declining over the past week. The fed funds futures market now puts 10% odds of a rate cut at the January FOMC meeting, compared with 18% on Friday and a peak of 50% on Sept. 1, according to Miller Tabak. The earliest the market perceives a 50/50 chance of a rate cut isn't until May 2007.

The 30-year bond fell 20/32 to yield 4.88%, while the 10-year note fell 14/32 to yield 4.75% and the five-year note fell 10/32 to yield 4.71%.

The Fed releases the minutes from the September FOMC meeting Wednesday, which should provide more guidance as to whether Goldilocks has really emerged from the forest. Whether earnings season muddles her path is yet to be seen.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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