Once again because of some family obligations tomorrow, I am writing this report a day earlier than usual.

After today’s market action, the Nasdaq is still holding above its 200-day moving average. As I indicated last week, if the index drops below that level then the long-term upward trend will be in jeopardy. At that point investors will need to watch market movement much more closely. Already though there are industry sectors that are doing much worse than the major market indices and investors who have held on to these positions have experienced substantial losses.

Recent market weakness has primarily been attributed to problems in the U.S. housing market. There is plenty of concern that slumping home sales and mortgage defaults will have a disastrous impact on the overall economy. For several years, real estate has been among the market’s strongest sectors. But as the chart below shows, that situation started to unravel earlier this year.

The gold line on the chart is DJ Wilshire REIT (RWR), a real estate ETF. The black line for comparison is the Nasdaq. Notice that since peaking in February, RWR has fallen about 28%. When the Nasdaq regrouped and began advancing again in March, the best RWR could manage was some sideways consolidation. Since April, its trend has been downward with sharp acceleration in the beginning of June.

Other funds in the real estate sector have seen similar declines. IShares Dow Jones US Home Construction (ITB) is down more than 25% so far in 2007. IShares Cohen & Steers Realty Majors (ICF) has dropped 12% in the past three months. Ultra Real Estate ProShares (URE) has lost more than 21% in that same time period.

I anticipate that we’ve seen the majority of the decline for the major market indexes, but not necessarily for the real estate sector. And as the correction in real estate deepens, it will begin to spill over into other areas. The building and construction stocks have already seen steep declines. Home improvement stocks will also suffer. In the financial sector, stocks of companies that invest heavily in real estate or in home mortgages are also likely to see some declines.

There are also some market sectors that continue to do well. High oil prices mean that the natural resource sector is going strong. Oil Services HOLDRs (OIH) is up nearly 20% over the past three months and there are many other natural resource ETFs showing gains of 15% to 20% over that same time.

In spite of market weakness, a number of technology funds are holding up well. Internet Architecture HOLDRs (IAH) is still up 14% over the past three months. Ultra Semiconductor ProShares (USD) is up more than 27%.

In the international arena, Pacific Rim and emerging markets funds still show solid gains, led by PowerShares Golden Dragon Halter USX China (PGJ) with a three-month return of 26%.

All of this points out the value of an active approach to investment management. Investors in the right sectors are feeling very little pain from this current market downturn, while those in the wrong sectors have already amassed some very damaging losses. At the same time, investors using a traditional asset allocation approach for diversification are likely seeing very little benefit because most asset classes remain highly correlated.
F.S.

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