A REVIEW OF MY MARKET VIEWS AND RECENT RECOMMENDATIONS -- RAISING CASH AND ROTATING TO DEFENSIVE GROUPS AND COMMODITY STOCKS -- RECENT REPORTS SUGGEST A SLOWING ECONOMY AND RISING INFLATION
REVIEW OF ELLIOTT WAVES... This is as good a time as any to review what I've been writing since the start of the year, and to clarify what advice I've been giving. Rather than repeat everything here, I invite you to review the headlines of my Market Messages since the start of the year. Go to the John Murphy tab and look under "Recent Updates". You'll see the headlines for the last three market messages. Click on "More Archived Updates" and you'll see the headlines for the updates going back several years. Click on any date and you'll get the entire update. You'll see a pretty consistent theme since the start of this year. Many of the 2005 headlines have to do with Elliott Waves. Some of them are "It Looks Like A Fifth Wave Up Is Starting" (February 1); "Market is In Fifth Wave of Fifth Wave" (February 4); and "Don't Wait for a Minor Fifth Wave to Sell" (February 9) . In several of those messages, I wrote about the possibility of a retest of the recent highs by the blue chip averages as part of the topping process. In the February 9 message I wrote "we've either seen the top or we're in the final rally leading to the top". I then advised "In either case, the best way to deal with that is to sell into rallies".
SECTOR RECOMMENDATIONS... I've also been sounding market warnings based on sector rotations. My January 19 headline was "Consumer Staples and Energy are Top Performers for 2005 -- Technology is the Worst -- That's Not Good For the Rest of the Market". In that same message I wrote: "My favorite sector play for this year is energy stocks -- and oil service stocks in particular". I added: "Stocks tied to commodities should continue to do well, especially when the dollar starts to weaken again". I updated that view on February 10 with the headline "Drop in Overbought Dollar Boosts Gold and XAU Index -- Rising Oil Supports Strong Energy Sector -- Basic Materials are Also Strong". On Tuesday and Wednesday of this week, I tied the upside breakout in basic materials to an upturn in commodity prices. On February 9 I also repeated my January advice to move some money into a money market fund to take advantage of rising short rates and/or rotate some money toward more defensive stock groups including consumer staples, healthcare, as well as large cap dividend-paying value stocks. That advice was predicated on my January 26 message entitled "2005 Doesn't Look Like A Good Year".
CLEARING UP SOME CONFUSION ... Some of our readers have expressed confusion on what exactly I'm advising. That's because it may sound like I'm recommending selling the "stock market" at the same time that I'm recommending buying "some" stocks. Here's what I'm saying. I favor taking "some" money out of the stock market. That money is probably best placed in a money market fund which should benefit from rising short-term rates. I've never advocated selling all of one's stocks. What I've advised is to move some of your remaining stock market funds to those parts of the market that are defensive in nature or that benefit from rising commodity prices -- especially basic materials and energy. I believe that commodities are in the midst of a long-term bull market and will be the strongest asset class for years to come. That's not necessarily good for the rest of the stock market because it means more inflation pressures and rising interest rates. And, if the stock market doesn't do that well for the next couple of years (which the four-year presidential cycle suggests), defensive market groups should hold up a lot better.
RECENT REPORTS SUGGEST WEAKER ECONOMY... I've explained that energy and consumer staple leadership is usually a sign of a weakening stock market and a peaking economy. So is the threat of rising inflation pressures resulting from a weaker dollar and rising commodity prices. Rising inflation eventually leads to higher bond yields. Recent reports suggest that some of those trends are already happening. Fourth quarter GDP growth was the slowest of the year; January's leading economic indicators dropped for the first time in three months; consumer confidence has fallen for the last two months; import prices jumped 0.9% in January; the January core PPI number (excluding food and energy) jumped to 0.8% which is the highest in six years. That's not the worst of the inflation news.
INFLATION IS IN THE PIPELINE... While the core PPI figure rose 2.7% from the previous year, "intermediate" goods rose 8.7% while "raw materials" rose 10.2%. Those larger numbers earlier in the inflation pipeline have two negative implications. One is that companies are being squeezed by higher costs for raw materials which is hurting their bottom line. That's bad for earnings. The other possibility is that companies start trying to pass those costs on to consumers. That means higher consumer inflation. Neither of those two possibilities is good for the economy or the stock market. The final kicker would be a jump in long-term interest rates. Mr. Greenspan's remarks this week that low bond yields were a "conundrum" and today's big inflation number have caused a jump in bond yields. Rising bond yields aren't good for a stock market that's in the final stages of a cyclical bull market and an economy that's already showing signs of slowing. Neither is another upleg in energy and commodity prices which appears to be starting.
TEN-YEAR T-NOTE YIELD JUMPS ... Mr. Greenspan's hints that long-term rates are too low, combined with today's big inflation number, pushed the 10-year T-note yield to the highest level in a month and back over its 50-day average. That's especially dangerous for interest-rate sensitive stocks and explains Friday's selling of financials, homebuilders, REITS, and utilities. The selloff in financials is especially troubling. After failing a test of its recent high, the Financials Select Sector SPDR (XLF) has fallen beneath its 50-day moving average. and it's doing so on heavy volume. That's a sign that the market is taking Friday's jump in bond yields seriously. Even more ominous is the fact that the financials' relative strength line has broken down to the lowest level in months. That means loss of financial leadership. Housing and real estate stocks are also vulnerable.
Chart 1
Chart 2
REAL ESTATE AND HOUSING STOCKS WEAKEN ... Housing and real estate have been the biggest beneficiaries of low long-term interest rates. The fact that bond yields have stayed so low for so long helps explain why the current real estate boom has lasted as long as it has. When long-term rates finally do start up, housing and real estate will be especially vulnerable. The next two charts compare 10-year T-note yield with the Morgan Stanley REIT Index. The charts show that the major uptrend in REITs (both in absolute and relative terms) began in early 2000 as bond yields started falling. Deflationary pressures pushed long-term rates to the lowest level in fifty years. That was a big boon to anything tied to housing. The downside of that is that housing and real estate may be vulnerable to any upturn in rates. We may have seen a dress rehearsal of that last year at this time when rates spiked and REITs dropped.
Chart 3
Chart 4
RISING RATES IN SPRING 2004 HURT REITS... Last spring long-term rates jumped from 3.7% to 4.9%. At the same time, REITs fell sharply as shown in Chart 6. They not only fell, but they fell much harder than the rest of the market as shown by their falling relative strength line. [Homebuilding stocks did the same]. The drop in long-term rates starting in June of last year helped launch another upleg in REITS. A closer look at the upper right of Chart 6 shows that the REIT Index has already started to drop (see box). Its relative strength line has also started to weaken (see circle). Any loss of upside leadership in the housing and real estate sector could be an early sign that long-term rates are headed higher. If that happens, real estate money may start looking for a new location.
Chart 5
Chart 6
THE SCALE HAS TIPPED TOWARD INFLATION... At the New York Expo last weekend, Martin Pring made the case that the battle between the forces of deflation and inflation had reached a critical inflection point. In other words, his charts showed that the deflation/inflation scale was about ready to tip in one direction. He arrived at that conclusion by comparing rate-sensitive (deflation) stocks with commodity-related (inflation) stocks. When rate-sensitive stocks are in the lead, deflation is dominant. When commodity-stocks lead, inflation is dominant (or becoming so). Which brings me to our last chart. It's a ratio comparison of basic material stocks to financials. With long-term rates rising this week, and inflation and commodity prices picking up, the week's strongest sectors were basic materials and energy. The weakest sector was financials. Chart 7 is a ratio of the Materials ETF (XLB) divided by the Financials ETF (XLF).
Chart 7
MATERIALS/FINANCIALS RATIO TURNS UP ... The fact that the ratio has been trading sideways for almost two years shows that deflation/inflation forces have been pretty evenly balanced (as the Fed has been pointing out). This week, however, the XLB/XLF ratio broke out to the highest level in three years. That tells me that the scale has finally tipped in favor of inflation. If inflation is no longer contained (as the Fed has claimed) it may have to abandon its "measured pace" and raise short-term rates faster and longer than it had planned to. Rising inflation expectations could boost long-term rates. All of these trends have important implications for investors. For one thing, it'll be better to be in inflation-sensitive stocks (like basic materials) than deflation-sensitive stocks (like financials). It also hints at higher interest rates -- both short and long. All of which seems to strengthen my negative view on the stock market and my preference for cash, commodity-related stocks, and defensive stock groups in general.
