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As a rule, you can judge the strength of a market by how well it reacts to bad news. Last week, the S&P 500 backed off 1% in response to the discovery of a terrorist plot based in London, the on-going violence in Lebanon, and the closure of Prudhoe Bay’s oil field. Under the circumstances, we think the market held up quite well – a little like Atlas, shouldering the weight of the world’s worst problems without collapsing.

Of course, this should not surprise you. For some time, our technical indicators have been remarkably positive. Relative strength in the broad market remains good. Speculation remains low, suggesting a lot of cash on the sidelines waiting for the right opportunity. And specialist shorting still lurks at historic lows.

In fact, even when the market rallies these days, the market specialists do very little shorting – a further sign that the specialists see no sell orders on their books. And without sellers, the buyers are in charge. So it’s no wonder the market stays buoyant.

Nonetheless, we refuse to grow complacent. There are a few trouble spots we are keeping our eye on …

LAGGING TRANSPORTS MAKE US DOUBT THE NEXT BULL

While most indices have been rising nicely, either at or approaching recovery highs, one index that stubbornly refuses to join in the general party atmosphere is the Dow Transportation Index. This would not be a problem, except that the Transport index is a leading indicator of economic activity. As we mentioned in a previous update, a bull market in transportation stocks is often considered essential to confirm an overall bull market.

Lately, the Transportation index has been lagging, which frankly worries us. Unless the transports find their spurs and catch up with the herd, we will doubt the sustainability of the next rally. We will be inclined to treat it as a selling opportunity.

TODAY’S RISK-SHY INVESTORS

Another curious characteristic of the market these days both gives us pause and makes us hope better days lie ahead. (It’s one of those non-committal indicators that’s worth paying attention to, but doesn’t actually scream “buy” or “sell.”) I’m referring to the fact that investors have become very adverse to risk.

This is particularly obvious looking at the energy sector. For instance, if you look at the charts for integrated oil companies, such as Exxon Mobile (XOM), they seem to be closely tracking the charts of defensive stocks, such as Proctor and Gamble (PG) – much more than the charts of oil service stocks. Oil service stocks, on the other hand, have been tracking the NASDAQ more closely than integrated oil stocks. This strikes us as odd. We normally expect energy stocks to move together as a group.

We believe the explanation has to do with volatility. “Volatility,” as I’m sure you know, is a two-edged sword of a word. When stock prices are rising, “volatile” can mean “rapidly growing” – a stock you can make a fortune from. On the other hand, and especially since the technology meltdown six years ago, “volatile” can also be a euphemism for “risky” – the kind of stock you should dump when prices start falling.

Integrated oil companies are not terribly volatile. A downturn in oil prices may dampen their profits, but usually not enough to affect their dividends. Exxon, for example, hasn’t had to cut its dividend in 40 years. If the economy caves in, and oil demand drops, integrated oil stocks such as Exxon, Chevron (CVX), or even ConocoPhillips (COP) will not be badly hurt.

Oil service companies are more volatile, more leveraged to the price of oil. A downturn in the economy that led to falling oil prices would severely affect their earnings, just as rising oil prices would cause them to skyrocket. Today’s investors have become quite wary of volatile, oil service stocks. And that suggests investors are concerned about potential weakness in the economy.

Investor concern is also reflected in today’s very low bond yields. We expect this week’s inflation figures will show the CPI is rising by over 4%, year-over-year. Meanwhile, real bond yields are close to zero. This is sign investors are scared of a downturn and are seeking the supposed safety of bonds.

The good news here is that the worst-case scenario seemed to be priced into the market. So if investors discover the economy is NOT going to cave in (say, for instance if the transports catch up to other sectors), that could result in the next leg of the rally, taking the market to new highs as well as recovery highs.

The biggest beneficiaries of the rally would be those stocks that have been lagging. Oil service stocks, for instance, would do very well, since they are currently trading at historically low P/E ratios. Even if oil were to fall below $60, these stocks could easily grow 15% to 20% a year.

So we remain optimistic in the near term, especially regarding oil service stocks. In fact, just to show you how “volatile” things are in oil, consider last week’s action …

PRUDHOE BAY BLUES

As we noted above, oil shot up initially last week on news that BP was shutting down oil production in Prudhoe Bay due to pipe corrosion. Prudhoe Bay represents roughly 0.5% of the world’s oil production. So normally, this event would be no more a big deal than if IBM moved up $0.40.

But Prudhoe is a big deal today because of the extremely tight supply/demand situation in oil. It shows just how vulnerable we are.

The other thing Prudhoe Bay exposed was the utter complacency on the part of major oil companies. Lord Brown, chair of BP, recently commented that BP will not embark on any project unless it is profitable with oil prices above $25 – as if he expected oil will return to $25 in the near future!

We think oil companies should be embarking on projects that would be profitable with oil over $50. And in time, anything profitable with oil under $100 a barrel will make good returns. But the longer it takes for the world to develop such projects, and alternative energy sources as well, the greater the supply/demand squeeze, and the higher energy prices and inflation will go.

And of course, all this will prevent stocks from rising in the long run.

Amylin (AMLN), one of our favorite speculative stocks, was hit last week when it was reported that a study showed the incidence of pancreatitis was higher among diabetic patients taking the company’s drug, Byetta, than among the broad population. This is an example of poor reasoning leading investors astray. The study actually showed that diabetics taking Byetta have a lower incidence of pancreatitis than diabetics in general. So pancreatitis is more likely a side effect of diabetes. Rather than causing pancreatitis, Byetta may actually help relieve it. We continue to believe Byetta will become one of the most profitable drugs this century, and that the current weakness in the stock is a buying opportunity.