LOWER BOND YIELDS FAVOR RATE-SENSITIVE STOCKS -- LOWER DOLLAR HELPS COMMODITY-RELATED STOCKS -- LARGE CAP VALUE AND DIVIDEND STOCKS ATTRACT MONEY

LOWER RATES HURT DOLLAR, BOOST CRB... Long-term rates have been dropping since June mainly due to signs of economic weakness resulting from rising energy prices. Chart 1 shows the 10-year T-note yield falling to the lowest level in four months and slipping beneath its 200-day moving average. That's caused a lot of intermarket relationships to kick in. The most obvious has to do with the dollar and commodities. Lower U.S. rates have weakened the dollar. Chart 2 shows the Dollar Index falling under its 200-day line along with falling yields. A comparison of the first two charts shows the dollar and bond yields tracking closely together. A weaker dollar has a bullish impact on commodity prices -- especially gold. Chart 3 shows the CRB Index turning up from major support near its 200-day average. It may seem strange to think of commodities as a rate-sensitive asset class. But they are. Lower rates mean a lower dollar which results in higher commodities. While oil has played a major role in the CRB rally, gold prices are especially sensitive to dollar trends. That's why gold and its related stocks achieved bullish breakouts this week.

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RATE-SENSITIVE STOCKS RISE... The drop in bond yields (and rising bond prices) has also increased the relative appeal of rate-sensitive stock groups -- such as financials, REITS, and utilities. The Morgan Stanley REIT Index hit a five-month high on Friday and has been outperforming the S&P 500 since May (Chart 4). The Dow Utilities recently hit a new 2004 high and have been showing relative strength since June (Chart 5). An upturn in banks and brokers this week is reflected in an upturn in the AMEX Financials Select SPDR (Chart 6). Its relative strength line has been rising since mid-July. This week's jump came on heavy volume which a sign of more aggressive buying and which has been notably lacking in the rest of the market. The financial ETF is close to crossing over its 200-day average, which would be another bullish sign. Chart 7 shows that the AMEX Bank Regional Holders have already exceeded their 200-day line.

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GOING FOR DIVIDENDS... A falling stock market -- along with falling bond yields -- should make dividend paying stocks more attractive. And that appears to be the case. Chart 8 plots the iShares Dow Jones Select Dividend Index Fund (DVY), which invests in large cap stocks that pay dividends. The Dividend ETF has acted much better than the rest of the market since last April as reflected in its rising relative strength line. Pricewise, the ETF hit a new four-month high earlier in the week. The two groups most heavily represented in the Dividend Fund are banks (38%) and electric utilities (19%). Other holdings include (in order of size) chemicals, tobacco, insurance, fixed line communications, and energy.

Chart 8

MOVING AVERAGE CROSSINGS ... Several stock groups achieved positive moving average crossovers this week. Those moving above their 50-day lines include the Bank Index (BKX), the Broker Index (XBD), and the Oil Service Index (OSX). [See Chart 9]. Stock groups crossing above their 200-day lines include the Morgan Stanley Cyclicals Index (CYC) and the Gold & Silver Index (XAU). [Chart 10]. In addition to those already mentioned above, stock groups that remain above both moving average lines are basic materials (which we showed yesterday) and telecomm- unications. [Chart 11]. Large cap value stocks continue to show good relative strength which is another sign of a defensive market. [Chart 12].

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S&P MONTHLY BARS OVERBOUGHT BUT STILL IN LONG-TERM UPTREND... The monthly bars in Chart 13 carry good and bad news for the S&P 500. First the bad news. The monthly stochastic lines above the chart are still weakening from overbought territory above 80 (see circle). In addition, the price bars show that the S&P bull trend stopped at its early 2002 peak (see box) -- after recovering half of the 2000-2002 losses. The good news is that the S&P remains above its (dotted) 20-month moving average (see arrow) which qualifies the current price drop as a correction as opposed to a bear market. And, finally, the monthly MACD lines which turned positive at the start of 2003 (see arrow) are still positive.

Chart 13

WEEKLY S&P BARS OVERSOLD, BUT STILL IN DOWNTREND... The weekly S&P 500 bars in Chart 14 also carry good and bad news. The good news is that the weekly stochastic lines are trying to turn up from oversold territory below 20 (see box). And, the weekly bars are finding support at their lower Bollinger Band (see arrow). The bad news is that prices remain beneath the dotted 20-week moving average (see blue circle); and the weekly MACD lines, which turned negative in early March, are still negative (see red circle) In my opinion, two things have to happen to improve the major trend picture. First, the S&P needs to rise above its 20-week average. Second, and more importantly, the weekly MACD lines need to turn positive. The short-term market trend has improved over the last week. But not enough to signal a major bottom.

Chart 14

DAILY S&P CHART IMPROVES -- BUT WITHOUT MUCH VOLUME... The final chart shows the daily bars in the S&P 500 SPDRs which have been climbing over the past week. The daily stochastic bars are rising from an oversold condition under 20 which is good; and the daily MACD lines have turned postive. That's the good news. The bad news is that volume has been light during the price rebound -- and prices remain below their 50- and 200-day moving average lines. In other words, the rally lacks institutional support and, so far at least, appears to be short-term in nature. Although the overall market trend remains negative, there are market groups that are showing superior relative strength. As the previous paragraphs suggest, however, those groups are generally defensive in nature and include financials, utilities, REITS, dividend-paying and value stocks along with commodity-related materials, gold, and energy. Whatever money is being invested is moving into those groups.

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