AIRLINES THRIVE ON FALLING OIL PRICES -- PLUNGE IN CATERPILLAR SHOWS WEAK HOUSING IS HAVING A NEGATIVE IMPACT ON CYCLICAL STOCKS -- CONSUMER STAPLES ARE BENEFITING FROM FEARS OF A SLOWING ECONOMY -- COCA COLA SURGES TO 52-WEEK HIGH

AIRLINES BENEFIT FROM FALLING OIL ... One of the cliches of the market is that the transportation sector is very energy sensitive. Over the last few years, however, that hasn't necessarily been the case. Rails and truckers have done reasonably well in the face of rising energy prices. Part of the reason is that increased shipping demand has enabled them to pass higher energy costs on to their customers. Airlines can't do that. As a result, airlines are the most energy-sensitive of the transportation stocks. That may explain why airlines have taking off lately while the Dow Transports have become market laggards. Chart 1 shows the inverse correlation between AMEX Airline Index (monthly bars) and the price of crude oil (black line) over the last ten years. Notice that upturns in crude (black arrows) have usually coincided with airline landings (red arrows). With crude having lost 25% of its value, airlines look like they're ready to take off.

Chart 1

AIRLINES INDEX NEARS 2006 HIGH ... With crude oil falling near its lowest level of the year today, the airlines are the market's strongest group (+3%). The red line in Chart 2 shows the Airline Index (XAL) moving closer to a challenge of its 2006 high. The rising relative strength ratio (gray line) for the XAL has turned up since August (when oil peaked). A brokerage upgrade of a couple of airlines has also attracted new buying to the group. The day's two upside leaders are Continental and American.

Chart 2

CONTINENTAL ASCENDS TO FIVE-YEAR HIGH -- AMR IS RIGHT BEHIND ... A brokerage upgrade in the two industry leaders shown below isn't hard to understand. The weekly bars in Chart 3 show Continental climbing to a new five-year high on very strong volume. It still has to overcome some turbulence in the 35-40 zone however, to contine its ascent. AMR is right behind CAL (Chart 4). AMR has chart resistance near 30 to overcome. Notice that the relative strength line for AMR is climbing (as it is for CAL). Strong price action and rising relative strength is a good combination for the airlines. So is falling oil prices.

Chart 3

Chart 4

CATERPILLAR HURT BY WEAK HOUSING ... A plunge in Caterpillar today unsettled the market. And for good reason. The bad news from the stock was blamed on a weak housing sector. Why that's worth noting is because Wall Street seems to be dismissing the housing meltdown as not very important. I beg to differ. There are subtle signs beneath the surface that weak housing is having a negative impact on parts of the market tied to the economy. Chart 5 attempts to show a positive correlation between Caterpillar (green line) and the PHLX Housing Index (brown line) since the bull market started four years ago. Both turned up together at the start of 2003 (green circle) and rallied together until the end of 2005. Notice that the plunge in housing stocks at the start of this year was followed shortly by a downturn in Caterpillar (red circle). That weak action isn't limited to CAT. It's generally true of most stocks tied to the economy.

Chart 5

WEAK HOUSING IS HURTING CYCLICAL STOCKS... The brown line in Chart 6 is the Housing Index (HGX). The blue line is a ratio of the Morgan Stanley Cyclical Index (CYC) divided by the S&P 500. The chart shows that economically-sensitive stocks have done much worse than the S&P 500 since May and shortly after the peak in housing. Cyclical stocks are very closely tied to the economy. The fact that they're doing so badly suggests that the market is already preparing itself for an economic slowdown resulting from the weak housing sector. It's no concidence either that some of the market's strongest groups have been in the defensive sector. I wrote yesterday about strength in healthcare and utilities. Another group that usually benefits when cyclicals (and the economy) weaken is consumer staples.

Chart 6

CONSUMER STAPLES ARE OUTPACING CYCLICAL STOCKS... When investors sense a slowing economy, money rotates out of economically-sensitive cyclical stocks into economically-resistant consumer staples. That rotation can be seen clearly in Chart 7. The blue line, which is the Cyclical Index, peaked in May. The red line, which is hitting new highs, is the Morgan Stanley Consumer Index (CMR). While the CYC includes stocks like CAT, the CMR includes beverage, food, drug, tobacco, and personal product stocks. They're defensive in nature. A more dramatic sign of their rotation is seen in their relative strength ratio beneath the chart. It's the CYC divided by the CMR. The RS line peaked in May and shows a move out of cyclicals and into consumer staples. That's what happens in a slowing economy.

Chart 7

Chart 8

CYCLICALS HAVE LED THROUGHOUT BULL MARKET ... Why the ratio in Chart 7 is important is shown in Chart 8. It plots the cyclical/consumer staples ratio for the last ten years. The upside breakout during 2003 helped launch the bull market in stocks (up arrow). Cyclical stocks had been the stronger group until this May (down arrow). Althought the downturn in the ratio hasn't reversed the four-year uptrend, it bears watching. It's not a sign of confidence in the market or the economy when cyclical stocks start to underperform defensive groups like consumer staples. One of the stocks in the Consumer Index that had a great day today was Coca Cola.

COCA COLA SURGES ON MASSIVE VOLUME. ... Coca Cola surged 4% today on massive volume to reach a 52-week high. While the stock may look over-extended after today's spectacular jump, that doesn't mean the stock is expensive. The monthly bars in Chart 10 show KO falling from 1998 to 2003. After trading sideways for four years, it's just now breaking an eight-year downtrend line. Its next upside target is 51 which was the peak formed early in 2004. On relative strength grounds (not shown here), the stock held up relatively well during the 2000-2002 bear market, but lagged badly after the 2003 bull market began. It's starting to outperform for the first time in four years. Combined with this week's upside breakouts in pharmaceuticals, there are lots of signs that more defensive stocks are coming back into favor.

Chart 9

Chart 10