BOND AND STOCK MARKETS REACH TRADING RANGE EXTREMES -- DEFLATION IN CPI AND PPI NUMBERS

STOCK AND BOND TRADING RANGES... It now appears that bonds and stocks have reached the extremes of their respective trading ranges -- stocks on the upside and bonds on the downside. On a short-term basis, that suggests that stocks should start to weaken while bond prices gain. Chart 1 shows the S&P moving to within 50 points of its fourth quarter high -- and its 200-day moving average. At the same time, Chart 2 shows Treasury bond prices starting to rally from chart support along its October low -- well above major support at its 200-day average. The bond chart is almost a perfect mirror image of the S&P chart. Charts 3 and 4 apply some technical indicators on the two markets.

Chart 1

Chart 2

STOCKS OVERBOUGHT, BONDS OVERSOLD -- NEITHER SHOW ANY DIRECTION... Chart 3 shows the S&P 500 starting to weaken after approaching the top of its multi-month trading range. The daily stochastic lines (which are among the most sensitive of our oscillators) are turning down from overbought territory over 80 -- giving the first short-term sell sign since early December. Chart 4 shows the exact opposite situation in Treasury bonds. The daily stochastic lines are oversold (under 20) and turning up. On a short-term basis at least, that's good for bonds but bad for stocks. Last evening we showed a flat ADX line (applied to the S&P 100) to show a lack of directional trend. The ADX lines on the two charts show the same situation. The red and green lines along the bottom of both charts reflect buying (green) and selling (red) pressure. It looks like the red line is about to cross over the green line for the S&P 500, which is negative. [The bond indicators are plotted through Thursday]. The flat (black) ADX lines show no directional movement in either market. That's one of the main reasons why we believe that both markets have entered into broad trading ranges. That also fits into our view -- expressed at the start of the new year -- for relatively flat markets for the foreseeable future.

Chart 3

Chart 4

WEAK ECONOMIC NEWS HURT DOLLAR... The stock market rally, and the bond market selloff, have been predicated on a better economy -- and stronger corporate earnings. A batch of weak economic news this morning has shifted the pendulum away from an overbought stock market back toward an oversold bond market. A weak consumer sentiment number along with soft industrial production figures were released this morning. That hurt stocks and helped bonds. A record U.S. trade deficit also took a toll on the U.S. dollar, which fell sharply as a result. We also suggested at the start of the month that a weak dollar would prevent a major upmove in stocks -- but would be good for gold stocks. We still believe that new lows in the dollar imply a weak U.S. economy, which should be enough to prevent an upside breakout in stocks. Weaker than expected inflation numbers released this week were also troublesome -- since they reflected a continuing deflation threat.

Chart 5

PRICES REALLY ARE FALLING... A negative PPI number of -0.3% was reported at midweek for December. According to the WSJ, core wholesale prices were down -0.4% for the year, the first time in 28 years that the U.S. has ended a year with annual declines in core wholesale prices. That's deflationary. Economists, however, took comfort in Thursday's small uptick in the Consumer Price Index. They used that to argue against the threat of deflation. However, an article in the WSJ this morning (CPI Reflects Big Split in Economy) argues that while service prices rose 3.2% in 2002, the price of "goods" actually fell 1.5%. The article also states that the combined drop in the cost of "goods" during November and December was the biggest drop in such prices on record going back to 1958. While the economists are focused on "inflation" in medical costs and college tuition, companies are being bled by "deflation" in manufactured goods. Despite the recent rise in commodity prices, the PPI and CPI numbers released this week show that deflation remains a very real threat to the economy and the stock market.