ECONOMIC OPTIMISM BOOSTS CYCLICALS -- STOCKS ARE RALLYING AT BONDS' EXPENSE -- CRB INDEX BOUNCES OFF 200-DAY LINE
BUYING CYCLICALS ... On Tuesday I showed the Materials Select SPDR (XLB) breaking through its summer high to achieve a bullish breakout. Materials were today's second strongest group just behind energy. Although there may be some inflationary meaning behind the new buying in these stocks, there's a second meaning having to do with the strength of the economy. To help make that point, I'm showing the Morgan Stanley Cyclical Index in Chart 2 which includes many of the same economically-sensitive stocks in the materials group (aluminum, copper, paper, steel, etc). Their relative strength ratios tell the tale. After lagging behind the S&P 500 all year, both ratios bottomed during October and have been market leaders since. The fact that oil prices had already peaked may have had something to do with their rebound. But they show that investors have become more optimistic on the economy. Another way to tell is to compare the relative performance of stock prices versus bonds.
Chart 1
Chart 2
BONDS FALL WHILE STOCKS GAIN ... Chart 3 compares the 2005 performance of the S&P 500 (price bars) versus the price of Treasury bonds (green line) which is the 20-year T-bond ETF (TLT). Earlier in the year bond prices were stronger than stocks which reflected economic fears. During the fourth quarter, however, bond prices have fallen as stocks have risen. That tells us two things. Investors are becoming more confident on the economy and that inflation pressures may be building. That carries good news for stocks over the short-run. It may carry bad news further out in time, however, if falling bond prices mean higher interest rates.
Chart 3
STOCKS VERSUS BONDS ... Chart 4 is a ratio of the S&P 500 SPDR (SPY) divided by the 20-year Treasury Bond ETF (TLT). The ratio bottomed in the autumn of 2002 and turned up in the spring of 2003. For the following year, stocks did better than bonds as the economy recovered from the previous bear market and recession. From the spring of 2004 to the middle of 2005, bonds did better than stocks possibly owing to concerns from rising energy prices. Since the start of October, however, the stock/bond ratio has broken its yearlong down trendline and has turned back up again. That means that investors are switching out of bonds and into stocks and especially those stocks that do well in a stronger economy. As I said, that's good news for the time being. But it could eventually turn into bad news if it means higher inflation next year along with higher interest rates.
Chart 4
BONDS FALL WHILE COMMODITIES RISE ... Chart 5 shows bond prices having completed a "double top" formation and meeting resistance at their 200-day moving average. The strong economic news of the past few days, and resulting stock market gains, have pushed bond prices lower (and bond yields higher). The CRB Index, which has been in a downward correction since September (when oil peaked), bounced more than six points off its 200-day moving average today. That's also consistent with signs of economic strength. Today's strong CRB rebound may start attracting even more money back into commodities (and their related stocks) and out of bonds.
Chart 5
Chart 6
