FALLING CRB BOOSTS BONDS -- ROTATION OUT OF ENERGY INTO CONSUMER DISCRETIONARY STOCKS -- BULLISH PERCENT INDEX TURNS UP -- FOUR-CYCLE LOW IS DUE THIS YEAR -- FALLING COMMODITIES ARE HURTING CANADA

FALLING COMMODITIES BOOST BOND PRICES... The biggest story in the financial markets has been the breakdown in commodity prices and energy in particular. One of the immediate beneficiaries of falling commodities is usually the bond market. That's because bond prices are very sensitive to inflation trends. Historically, bond and commmodity prices have trended in opposite directions (most of the time). Chart 1 compares the two markets over the last year. The daily bars represent the Reuters/Jefferies CRB Index which has just fallen to the lowest level in more than a year. The solid green line is the 7-10 year T-bond ETF (IEF). During the first half of the year, rising commodity prices were accompanied by falling bond prices. In mid-May, however, both markets changed direction. Commodities peaked while bond prices bottomed. Since then, bond prices have risen while the CRB has fallen. [The IEF, however, is nearing its 2006 peak which could act as a resistance barrier]. When bond prices rise, bond yields fall. Falling bond yields, combined with falling energy prices, gave the stock market a boost this week. For the first time since May, we saw money switching out of former defensive groups like consumer staples and utilities and back into brokers and retailers. Thanks to the latter group, the week's top sector was consumer discretionary stocks.

Chart 1

CONSUMER DISCRETIONARY SPDR TESTS OVERHEAD RESISTANCE ... Sparked by a rally in retailers (and a bounce in homebuilders), the Consumer Discretionary SPDR (XLY) went from one of the market's weakest sectors during 2006 to the strongest. It's relative strength (blue) line is still in a downtrend, but had one of the strongest week's of the year. The red line shows the improvement in the price trend of the XLY. It went from the bottom of its two-year trading range to the top in very quick fashion. The bigger question will be whether it's able to surmount the three previous peaks formed since the start of 2005. Consumer discretionary buying came at the expense of energy stocks.

Chart 2

ENERGY STOCKS FALL OUT OF FAVOR ... Chart 3 is the flip side of the rally in consumer discretionary stocks. It shows the sharp downturn in the Energy Select SPDR (XLE) over the last month. Actually, the topping process began in early May when the XLE peaked at 60. The early August top was a failed attempt to exceed that earlier peak. That's how tops usually form. Problem is we can't be sure yet that it is a major top. The chart shows the XLE still trading over its July low at 49.83. It would have to break that low to complete a "double top" reversal pattern. The XLE/S&P relative strength line has already broken its summer low which shows how unpopular energy stocks have become. Energy has gone from the year's strongest group to the weakest.

Chart 3

ANOTHER LOOK AT THE BULLISH PERCENT INDEX ... One of our readers asked for my read on the S&P 500 Bullish Percent Index. Charts 4 and 5 shows two versions of what it looks like at present. The BPSPX measures the percentage of stocks in the S&P 500 that are on point & figure buy signals. Generally speaking, readings over 70 represent an overbought market. The last downturn from that level in early 2006 was an early sign of a weakening market. It's important, however, for the market to find support around its 50 line. That's because 50 is usually the dividing line between bull and bear markets. A decisive drop below 50 signals a shift from a bull to a bear market. So far, that hasn't happened. In fact, the BPSPX bounced off 50 and is starting to rise again. Chart 5 shows the p&f version of the chart which is the one generally used for trading signals. It paints a more friendly picture than it did a couple of months ago. During July (number 7), the last o column was threatening the bottoms of two previous o columns and its rising 45 degree support line (the o columns show falling values). Fortunately, it has since bounced off those support levels. During September (represent by number 9) the last x column exceeded a previous x column, which is technical buy signal. [The last green x represents today's price action]. The main message of the chart is that the S&P 500 avoided turning into a bear market during the summer and is attempting another upleg.

Chart 4

Chart 5

S&P 500 TESTS ITS MAY HIGH ... During August, when the S&P 500 broke through its July peak at 1280, most chartists started calling for a retest of its May high at 1326. The S&P is just about there. One of the market's problems during most of that summer rally was lack of upside volume. That may have been due to usually slow August trading, but it has caused the on balance volume (OBV) line (below the chart) to lag behind the price action. Volume did pick up noticeably this week, however, as prices rose. Although the market's internals have improved (the NYSE advance-decline line has reached a new record), the S&P still has to contend with potential profit-taking around its old high.

Chart 6

WHAT ABOUT THE FOUR-YEAR CYCLE ... I've received a number of questions on the status of the four-year cycle. The stock market has shown a very consistent pattern of forming important bottoms every four years -- usually during the fourth quarter. The last bottom took place in October 2002, which makes another one due this year. The only problem is that most of those four-year bottoms occurred after a weak year (like 1990 or 1998) or a year in which prices moved sideways (like 1994). That makes this year's action somewhat unusual. My original market outlook had been for a weaker market into October followed by a probable upturn. So far, the market has held up much better than I had anticipated over the summer months. Although the market still needs to weather the seasonally dangerous September/October months, the four-year cycle should act as a bullish prop under the market on any selloffs. The green arrows in Chart 7 show the last four cycle bottoms in 1990, 1994, 1998, and 2002. If the cycle repeats itself, another four-year bottom is due this year.

Chart 7

COMMODITY DROP IS HURTING CANADA... I recently suggested that the drop in commodity prices might start to hurt the stocks of countries tied to raw materials. One of those countries is Canada. While the U.S. market is testing its highs for the year, the Toronto 300 Index (TSE) in Chart 10 is trading beneath its 200-day moving average. Even more striking is the breakdown in the TSE/S&P 500 ratio over the last month. Since it exports so many raw materials, Canada has benefited from the commodity boom over the past five years. I suspect that falling commodity prices are now working against our northern neighbor.

Chart 8