SECTOR ROTATION MODEL SHOWS THAT STOCK MARKET IS LEADING INDICATOR FOR THE ECONOMY -- WHY RECENT SECTOR ROTATIONS MAY CARRY A WARNING -- MARKET'S RALLY ATTEMPT FADES AS 200-DAY LINE REMAINS THREATENED

STOCKS LEAD THE ECONOMY... Over the weekend, I explained why we can't use the economy to predict the stock market. Because stocks turn down six to nine months before the economy. That doesn't mean that every market downturn leads to an economic slowdown or recession. That's certainly not the case. But it is true that every economic slowdown (or recession) has been preceded by a stock market top. That makes the stock market a "leading indicator" of the economy. When the media interviews economists during a stock market drop, it has things backwards. You can't use a lagging indicator (the economy) to predict the direction of a leading indicator (the stock market). It's actually the other way around. The diagram in Chart 1 is an idealized version of a Sector Rotation Model. It tells us which sectors do best at different stages of the business cycle. It also tracks the stock market relative to the economy. The red line is the stock market while the green line represents the economy. The diagram shows that the stock market peaks (and bottoms) before the economy. Trying to predict a market top by waiting for economic numbers to slow is like driving a car by only looking out the rear window.

Chart 1

RECENT SECTOR ROTATIONS CARRY A WARNING ... The diagram in Chart 1 shows that the last two sectors to start rolling over at a market top are basic materials and energy. At the same time, worried traders start moving toward more defensive sectors like consumer staples and utilities. Having said that, I invite you to take a look at "John's Latest Performance Chart" in Chart 2. The chart shows which groups have held up better than the S&P 500 over the last month (the ones to the left) and which have done worse (the ones to the right). All groups actually lost ground. By plotting the S&P 500 as the zero line, however, we can see "relative" performance more clearly. The two top sectors over the last month have been consumer staples and utilities. Two of the worst have been materials and energy. It's too soon to tell if those rotations have major trend significance, or are just short-term corrections. If the market were starting to peak, however, the Sector Rotation Model suggests that the relative performance picture in Chart 2 is exactly what we would see.

Chart 2

GOLD IS HOLDING UP PRETTY WELL ... I've been asked why gold didn't do better during the recent market selloff. Actually, gold held up relatively well. Chart 4 shows the streetTrack Gold Trust (GLD) trading above its moving average lines. The more important line is the relative strength ratio at the bottom of chart (orange line). That line rose during July, which means that gold held up better than the stock market. One of the reasons that gold did lose some ground has to do with rising volatility and the nature of recent market selling. A lot of the selling has come from hedge funds who deal in both stocks and commodities. Margin calls on losing stock positions (especially highly leveraged ones) may have forced them to sell winning positions in gold to raise cash to meet those margin calls. In times of rising volatility, markets also tend to become highly correlated. In other words, everything drops -- including foreign markets. I still believe that the long-term picture for gold is positive. That's especially true if future events were to force the Fed to lower interest rates and the dollar were to weaken as a result.

Chart 3

NYSE ADVANCE DECLINE LINE NEARS 200-DAY AVERAGE... Virtually everywhere we look within the stock market we see important market indexes (like the S&P, the NYSE, and the Nasdaq) testing their 200-day moving averages. So are a number of group indexes within the U.S. market as well as foreign stocks. Here's another one to consider. Chart 4 shows the NYSE Advance-Decline line (plotted through Friday) bearing down on its 200-day line. That will be an important test because the AD line hasn't broken that major support line since the bull market began more than four years ago. It may also be worth noting the size of the recent drop in the AD line. It's dropped 12% from its June high. By comparison, the AD line lost only 5% during its February/March correction and 10% in the spring of 2006. That makes this breadth correction worse than the two previous downturns. That's consistent with recent weakness in financials and small caps -- as well as the unusually high number of big board stocks hitting new 52-week lows.

Chart 4

BOUNCE OFF 200-DAY LINE ISN'T VERY IMPRESSIVE... Chart 5 is pretty symptomatic of the current state of the stock market. It shows the NYSE Composite Index trying to stabilize at its 200-day moving average. Unfortunately, today's bounce attempt was less than impressive. Although the market was in the black most of the day, it ended slightly lower. Even during the bounce, volume was light. Breadth was about even with big board gainers holding a slight edge over losers (17 to 15). [Nasdaq breadth was slightly negative]. Part of the problem today was renewed selling in financials and small caps. Not to mention the fact that homebuilders fell 2% (Chart 6). With all the recent talk about central banks providing liquidity to global markets to ease the subprime problem, it's important to recognize that housing is still in a major decline which shows no signs of ending. Today's better-than-expected retail report gave economists some hope of a pickup in consumer spending. Retail stocks, however, weren't as hopeful. Chart 7 shows the Retail Holders closing down today and still trading well below their 200-day moving average. I've suggested before that retail weakness is probably linked to the housing meltdown. That's not a good sign for consumer spending which is two-thirds of the U.S. economy. I remain puzzled as to why economists aren't more worried about that. As for the stock market, it's in a short-term oversold condition and is certainly entitled to a bounce of some type. If the market is going to mount a rally off of its 200-day moving average, however, it's going to have to do a lot better than it did today. So will brokerage stocks which lost -1.5% and continue to weigh on the rest of the market (Chart 8).

Chart 5

Chart 6

Chart 7

Chart 8