OVERBOUGHT MARKET PULLS BACK BEFORE INFLATION REPORTS -- BOND YIELDS NEAR TWO-YEAR HIGH

MAJOR AVERAGES PULLING BACK ... Last Wednesday I showed Chart 1 to make the point that the S&P 500 SPDR was up against chart resistance near 115 (its April highs) and that the stochastic lines were in overbought territory over 80. That suggested that some short-term selling wouldn't be surprising. We're getting some of that today. As I suggested last week, there's potential chart support for the S&P 500 SPDRs between 112 and 112.50. Chart 2 shows the Nasdaq 100 Shares (QQQ) backing off from chart resistance just over 37.00. The QQQ is heading down for a test of moving average and chart support in the 36.00 35.75 region. We'll be watching the volume very closely during this pullback. Volume was disappointingly light during the recent market rebound. The last thing we want to see now is heavier trading on the downside.

Chart 1

Chart 2

CONSUMER STAPLES DO OK WITH RISING RATES... A look at the day's sector activity strongly suggests that the market is focused on this week's inflation reports and the threat of higher interest rates. [The CPI is due tomorrow and the PPI later in the week]. That explains why today's biggest losers are in financials, housing, materials, and technology. All are especially vulnerable to rising rates. The sectors holding up the best are consumer staples, healthcare, utilities, and energy. The first three are defensive in nature. Energy is part of the problem. Since the start of the year, consumer staples and energy have been the market's two strongest sectors. A strong energy sector means higher inflation and higher rates. Consumer staples do relatively well in a climate of rising rates. Chart 3 shows the Consumer Staples Select Sector SPDR hitting a new high last week. Although it's pulling back today, it's holding up better than the rest of the market. Some of today's staple leaders are Albertsons, Anheuser Busch, RJ Reynolds,and Safeway. Chart 4 shows Safeway breaking out to a new eight-month high on rising volume.

Chart 3

Chart 4

SOX PULLS DOWN NASDAQ... The Nasdaq is the day's weakest index. Part of that has to with relative weakness in the Semiconductor (SOX) Index. Chart 5 shows why the recent SOX action is some cause for concern. The recent rebound failed twice to stay above the (red) 200-day moving average. The SOX also backed off from the down trendine drawn over the January/April highs. The SOX is now threatening the low of two weeks ago. Its relative strength line is starting to weaken as well. Weakness in the SOX usually pulls the Nasdaq lower which weakens the rest of the market.

Chart 5

YIELDS NEAR TWO-YEAR HIGH ... Here's what the market is worried about. The 10-year T-note yield is moving dangerously close to its May peak at 4.90%. That peak represented a two-year high. The weekly bars in Chart 6 put the trend in perspective. Long-term rates bottomed last summer. After pulling back into March of this year, the 10-year yield broke through last summer's peak to turn the major trend higher. That's the market's way of telling us that the Fed has fallen behind the curve and has to do some catching up. The market had discounted a gradual tightening by the Fed. It hasn't discounted a more aggressive policy. That's why this week's inflation reports are so important. If they come in high, they may force the Fed to act more aggressively later this month.

Chart 6