WEAK CPI REPORT BOOSTS BONDS AND STOCKS -- FALLING DOLLAR BOOSTS GOLD -- S&P 500 REACHES NEW THREE-MONTH HIGH

JULY CPI HAS SLOWEST GAIN IN FIVE MONTHS ... The market got a second dose of good news on inflation in two days. On the heels of yesterday's weak PPI number, today's report showed a gain of only 0.2% in the July core CPI number which is the smallest gain in five months. That gave the markets more encouragement that the Fed may be able to avoid another rate hike next month. Weak housing numbers also confirmed that the economy is slowing. As happened yesterday, bond and stock prices rose as the dollar dropped. Chart 1 shows the 10-year Treasury Note yield falling to another four-month low (as bond prices rose). One casualty of falling U.S. rates is the dollar. And for the second day in a row, the U.S. Dollar Index has fallen (Chart 2) after failing a test of its 50-day moving average. Strong economic news from Europe this week (and recent rate hikes by the ECB) strengthened the Euro and most other foreign currencies. A falling dollar usually gives a boost to gold and it's doing that today.

Chart 1

Chart 2

GOLD AND GOLD SHARES BOUNCE... Gold and gold shares are bouncing today on the falling dollar. Not enough to change their short-term trend which remains sideways. But enough to keep the Gold ETF (GLD) and the AMEX Gold Bugs Index (HUI) above their 50-day moving averages. Silver continues to do better than gold. Other commodities, however, remain on the defensive. Crude oil has fallen to a four-week low and the CRB Index has fallen back to its 200-day moving average. That may also encourage the view that inflation pressures are moderating. That may work in gold's favor if the dollar continues to weaken. Another side-effect of a weaker dollar is stronger foreign stock market ETFs.

Chart 3

Chart 4

EAFE SHARES OUTPERFORM THE U.S. ... A falling dollar benefits foreign markets in two ways. It makes foreign markets more attractive to American investors (and U.S. markets less attractive to foreigners). Since foreign stock market ETFs are also quoted in U.S. dollars, they also benefit from a weaker dollar and stronger foreign currencies. The next chart shows the EAFE Index iShares climbing to a new three-month high. [EAFE stands for Europe Australia and the Far East and is the benchmark for foreign stocks]. More importantly, its relative strength ratio (versus the S&P 500) is also at a three-month high. That may also be based on the view that the U.S. economy is slowing (lower interest rates) at the same time that foreign economies are strengthening (rising interest rates). That's why foreign stock ETFs are acting even stronger than U.S. stocks at the moment.

Chart 5

S&P 500 EXCEEDS JULY PEAK ... Yesterday I wrote about how the Nasdaq market had exceeded its 50-day moving average for the first time in three months and appeared to have embarked on a rally. Another 4% gain by semiconductors today is contributing to technology gains. Broader market indexes are doing even better. Chart 6 shows the S&P 500 reaching a new three-month high today. One of our readers asked what to do with his existing short positions. On July 28, when the S&P was moving up to test the 1280 level, I suggested what to do with short (or bear) positions if that level were broken (July 28, 2006). I pointed out that short-term traders should have already covered bear positions, but that those with an intermediate-term perspective should do the same if the 1280 level was exceeded. That's now happened for two consecutive days. That means that all or most short positions should now have been covered. I also suggested some "selective nibbling" on the long side. Some groups that I mentioned in that article were banks, gold, drugs, and telecom. I also favor large cap stocks over small caps. In the technology sector, I recommended Software Holders (SWH) yesterday. Bottom-fishers might consider some nibbling in the semiconductor group. I remain doubtful that this is the start of major new upleg. But clearly the market's trading trading is being extended to the upside. As I also suggested on July 28, it's not advisable to fight the tape or the Fed.

Chart 6