CYCLICAL BREAKDOWN IS BEARISH FOR THE MARKET AND THE ECONOMY -- WHY CHARTS WORK BETTER THAN ECONOMIC ANALYSIS -- DOW FALLS TO 2005 LOW ON RISING VOLUME -- BEAR MARKET FUNDS SHOULD LOOK GOOD
CYCLICAL STOCKS TAKE A BEATING ... One of the best ways to predict the direction of the economy is to follow the trend of major market averages. That's because the market is one of the best economic indicators of all. Since the start of 2005, those market averages have been hinting at economic weakness. Since the start of the year, however, I've focused more on the message of economic weakness being given by sector rotations. I've written about how energy leadership was bad for stocks. I've also written about new leadership by defensive groups like consumer staples, healthcare, and utilities being signs of a peaking market. At the same time, breakdowns in technology, financials, and retailers provided even more signs of economic slowing. The recent plunge in rails and truckers is another symptom of weakness. Charts 1 and 2 show how a comparison of cyclical and consumer stocks have been sending a negative message.
Chart 1
CYCLICAL INDEX LEAD MARKET LOWER... Chart 1 is a chart of the Morgan Stanley Cyclicals Index (CYC). As the name implies, it is made up of stocks that rise and fall with the business cycle. It includes the likes of Alcoa, Caterpillar, CSX, Dow Chemical, Ford, Honeywell, 3M, Phelps Dodge, and U.S. Steel -- and many more. Many of the stocks are also in the basic material category which has tumbled this week. Chart 1 shows the CYC trading at a new 2005 low and breaking its 200-day moving average. That's obviously bad for stocks in the cyclical group. But there's a broader message being given by their breakdown. The CYC/S&P relative strength ratio is plotted below the price bars in Chart 1. Notice that it's already broken a yearlong support line. That means that economically-sensitive stocks, which had been leading the market higher for most of the cyclical bull market, are now leading it lower. That's also a sign that the market (which looks six to nine months into the future) is expecting an economic slowdown. Chart 2 shows another side to that bearish story.
Chart 2
CONSUMER STOCKS HOLD UP BETTER ... Chart 2 is a chart of the Morgan Stanley Consumer Index (CMR). It includes more defensive stocks like drugs, food, beverages, tobacco, and household products. These types of stocks are considered economic-resistant. In other words, they're not as effected by a downturn in the economy as economically-sensitive cyclical stocks. One way we can tell when the market is weakening is when defensive stocks start doing better than the market. And that's what Chart 2 shows. The Consumer Index is still holding over its 50-day average as the rest of the market is testing its 2005 lows. Most of these stocks are also in the consumer staple and healthcare categories that I've written about previously. Here again, notice the upturn in the CMR/S&P relative strength ratio. It started to bottom in December and has now risen to the highest level in eight months. When defensive stocks are doing better than the S&P 500, that's another way of telling that the market is looking toppy. Chart 2 also shows that the type of defensive stocks in the CMR are a safer place to be in a market downturn.
Chart 3
WHY WE LOOK AT CHARTS ... I was struck by several stories in today's financial papers that demonstrate the basic difference between chart analysis and economic analysis. The difference has to do with the fact that markets are leading indicators of the economy. Economic indicators by contrast are backward looking. In other words, they're lagging indicators. Yesterday's market downturn (which got even worse today) started with very disappointing retail numbers. The NY Times quoted one economist saying "The sluggish retail sales suggest that high and rising energy costs may be cutting into discretionary spending". A chief economist wrote that the weak retail report "pulled down our assessment of consumer spending". Investors Business Daily wrote that "the retail sales report spurred some economists to trim first quarter GDP growth forecasts". My question is why it took until yesterday for economists to figure out that rising energy prices hurt consumer spending. Isn't that taught in Economics 101?
RETAIL STOCKS HAVE BEEN TUMBLING ALL YEAR... What's shocking to me is that it took a weak retail report yesterday to turn economists cautious. Aren't they -- and the rest of Wall Street -- aware that retail stocks have been tumbling all year? Readers of this column were. Chart 3 is an updated version of a chart I posted on April 1 accompanied by the headline: "First Quarter Sector Rankings Paint Negative Picture -- Retailers Lead Market Lower" (April 01, 2005). The first paragraph ends with "While economists continue to debate what effect rising energy prices are having on the consumer and the economy, sector rotations paint a pretty clear picture of a stock market that's peaking -- and an economy that's slowing down". And therein lies the difference. Economists wait for old economic numbers to figure out what's going on. Chartists study the markets which are leading indicators of the economy. And that's why, in my opinion, market charts are superior to economic and fundamental analysis.
Chart 4
DOW FALLS TO NEW 2005 LOW -- THAT'S GOOD FOR BEAR FUNDS ... Today was a bad chart day. Most of the major market indexes fell to new 2005 lows on rising volume. Some of them, like the Dow, also broke 200-day moving averages. That means that the market has taken a serious turn for the worst. The only good news is that several bear market funds probably experienced upside breakouts today. We'll chart some of them tomorrow.
