KROGER LEADS CONSUMER STAPLES HIGHER -- VERIZON HELPS THE DOW -- ROTATION OUT OF ENERGY INTO CONSUMER STAPLES ISN'T A GOOD SIGN -- NEITHER IS DOW STRENGTH AND SMALL CAP WEAKNESS

CONSUMER STAPLES ARE DAY'S TOP SECTOR... With today's stock market rally fading again, investors continued to favor the defensive qualities of consumer staples. That made consumer staples the day's top sector. That's nothing new. Chart 1 shows the Consumer Staples Sector SPDR (XLP) trading well above its 50-day moving average. Even more impressive is the XLP:SPX relative strength ratio which bottomed in April and has risen to a new 2006 high. That's a sure sign that the group is being viewed as a relatively safe harbor in a weakening market environment. Today's staples star was Kroger which gained 5% on the day.

Chart 1

KROGER SURGES ON HEAVY VOLUME ... The large supermarket chain surged 5% today on the heaviest volume for the year. That's a bullish combination. The daily bar chart shows the stock not far from its 2006 high. Its relative strength ratio is already trading at a new high for the year. The monthly bars in Chart 3 put the stock's performance in better historical perspective. It shows the stock nearing a four-year high. Its relative strength ratio also appears to carry an important message. The last time the stock turned up relative to the S&P 500 was at the start of the 2000 bear market (first up arrow). The stock has underperformed the S&P 500 since 2002 when the market bottomed. The second blue arrow, shows the KR:SPX ratio having broken a four-year down trendline. That's what defensive stocks like consumer staples are supposed to do in a stock market that appears to have ended its three-year cyclical bull run. Costco and Safeway also had good day's in the consumer staples group. The monthly bars in Chart 4 show Costco nearing a test of its 2000 peak. Its relative strength line has already reached a new record. Chart 5 shows Safeway trying to break out of a three-year basing pattern. Its relative strength line is rising for the first time in five years.

Chart 2

Chart 3

Chart 4

Chart 5

ENERGY SECTOR IS DAY'S WEAKEST SECTOR... While consumer staples were the day's strongest sector, energy was the weakest. The next chart shows the Energy Sector SPDR (XLE) closing back below its 200-day moving average. Its relative strength ratio peaked in May and has been falling since then. The XLE is also in danger of falling beneath its March low. There may be a hidden message in that as well. Chart 7 shows what it may be.

Chart 6

ROTATION OUT OF ENERGY INTO CONSUMER STAPLES ... On May 16 I wrote a paragraph on Sector Rotations that explained the normal rotation process at market tops (May 16, 2006). I explained that a peak in late-cycle stocks like energy was usually a bad sign for the market. At such times, money tends to flow into more defensive groups as investors turn more cautious. The first defensive group that they usually move to is consumer staples. One way to monitor the relationship between a falling energy sector and a rising consumer staples sector is with a relative strength ratio. And that's what the next chart does. Chart 6 is a ratio of the Consumer Staples SPDR (XLP) divided by the Energy SPDR (XLE). The chart shows the ratio bottoming during May and moving up to exceed its 200-day moving average. That's the first time that line has been broken since 2003. That's the market's way of telling us that something has changed. For the first time in nearly three years, consumer staples are doing better than energy stocks. That type of rotation is commonly seen at market tops.

Chart 7

VERIZON HELPS SUPPORT THE DOW... Speaking of defensive stocks, I wrote yesterday about new signs of leadership from telecom stocks like AT&T and Verizon, and how they were helping to support the Dow Industrials. Right on cue, Verizon was the Dow's top percentage gainer today. The daily chart shows VZ closing comfortably over its 50-day average on rising volume. Its relative strength line (versus the Dow) reflects the new leadership from some of the big telecom stocks. That helped keep the Dow in the black today while most other market indexes lost more ground. Merck was another Dow leader today (Chart 9).

Chart 8

Chart 9

DOW OUTDOES SMALL CAPS ... I wrote yesterday that the ability of the Dow to hold up better than small caps isn't a good sign for the market. It's in fact a sign of a defensive market. That's why the Dow is the only major market index that's still trading over its 200-day moving average while small cap (and most other) indexes remain below that long-term support line. That's one way of shower relative strength in the Dow. A better way to study their relationship, however, is with the relative strength ratio shown in Chart 10. Its a ratio of the Dow Industrials divided by the Russell 2000 Small Cap Index. The ratio peaked at the start of 2003 (down arrow) and fell throughout the cyclical bull market in stocks. That's normal since growth-oriented small caps usually do better than value-oriented Dow stocks in a bull market. To the bottom right, however, you can the Dow/RUT ratio turning up enough to break the three-year down trendline (up arrow). The message of that rising Dow/RUT ratio is similar to the XLP/XLE ratio in Chart 7. Investors are preparing for a more serious market downturn.

Chart 10