WEAK DECEMBER JOBS REPORT PUSHES BOND YIELDS SHARPLY LOWER AND BOND PRICES HIGHER -- THAT ALSO BOOSTS DIVIDEND PAYERS LIKE REITS AND UTILITIES WHICH OFFER BETTER RETURNS THAN BONDS

BOND YIELD PLUNGES ON WEAK JOBS REPORT... Friday's news that American employers added only 74,000 jobs in December didn't have much of an effect on the broader stock market, but did shock bond investors. Chart 1 shows the 10-Year Treasury Note Yield ($TNX) suffering the worst drop since September. In so doing, the yield fell back below its early September peak just below 3%. Friday's plunge kept bond yields within its second half trading range between 3% on the upside and 2.5% on the downside. Bond prices jumped sharply as yields fell. Stocks tied to bonds also had a strong day. They include bond proxies like utilities and REITS. Homebuilders also had a strong day, as did dividend-paying stocks. So did gold and other precious metals. All had been hurt during 2013 by rising bond yields. Friday's action may have been an over-reaction to one month's report (most likely influenced by bad December weather). Portfolio rebalancing may have also played a role. One of the time-honored practices is to "rebalance" one's portfolio at the start of a new year. That involves moving some funds out of the previous year's winners (like stocks) and into the biggest losers (which are bonds). Some money managers are suggesting, however, that some money earmarked for bonds might be better placed in stock categories tied to bonds. The reasoning is that "bond proxies" offer the possibility of capital appreciation if stocks continue to rally. Since those groups were underperformers during 2013, they may offer better value at current levels, and some protection against an over-extended stock market that is entering a dangerous year.

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Chart 1

SECOND YEAR OF PRESIDENTIAL TERM IS USUALLY THE WORST... My December 14 message carried the headline: "The Four-Year Presidential Cycle Suggests That 2014 Could Suffer a Major Downside Correction". That message also carried the above headline to the effect that the second year of a president's term (which coincides with midterm elections) is usually the most dangerous. [The article also suggested, however, that a downside correction would most likely set up a major buying opportunity later in the year]. I repeat that warming here to suggest that a downside correction in stocks would most likely lead to a rebound in bond prices. That's because bond and stock prices are negatively correlated. The weekly bars in Chart 2 show the a drop in the 20+Year Treasury Bond iShares (TLT) during 2012 and 2013 (down arrows) coincided with a strong S&P 500. To the bottom right, however, the bond ETF is stabilizing above its summer low (see box). That doesn't end the major decline in bond prices that started last year (and should resume later this year). It may, however, be hinting at a stock market in need of a period of consolidation or correction. That should also benefit bond-related stocks groups like utilities and REITS.

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Chart 2

REITS AND UTILITIES SHOULD DO BETTER THAN BONDS ... While bond prices are "negatively" correlated to the broader stock market, they're "positively" correlated to stock groups that pay high dividends like utilities and REITS. Such groups are referred to as "bond proxies". Chart 3 shows that positive correlation between bond prices, utilities, and REITS. During 2013, the S&P 500 rose 30% while the Bond ETF (TLT) lost 10%. During that same year, however, the Utility SPDR (XLU) gained 13% while REITS gained 4%. While those two rate-sensitive groups underperformed the S&P 500, both did better than bonds. That being the case, they may offer better diversification against a stock market correction than bonds themselves. They also offer better yields. While the 10-year note currently yields only 2.86%, utilities and REITs yield around 4%.

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Chart 3

HOMEBUILDERS TURN UP ... Homebuilders are my favorite rate-sensitive group. That's mainly because they have the strongest chart pattern. Chart 4 shows the Dow Jones U.S. Home Construction iShares (ITB) having risen above a resistance line drawn over its second half highs. After consolidating during the first week of the year, it jumped sharply on Friday (helped by the drop in bond yields). Its relative strength ratio (solid area) has been rising since December as well. A glance at the bond price (green line) shows that homebuilders suffered from last year's bond plunge. They also started to bottom during August and September when bond prices bottomed. What's most impressive is the ability of homebuilders to turn up in advance of this week's bond bounce. That suggests that the group is benefiting from an anticipated bounce in an oversold bond market (which suggests a pullback in bond yields and mortgage rates), but also expectations for a stronger economy which would boost homebuying. That qualifies homebuilders as a good compromise between economically-sensitive and rate-senstive stocks. For those investors who are optimistic on the longer range trend for stocks and the economy (as am I), but who are concerned that 2014 may see a correction in stocks (which I am), homebuilders appear to offer a good middle ground.

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Chart 4

RECAP OF 2014 FORECAST ... My December 14 message described a likely scenario for the presidential cycle to play out during 2014 which I'll summarize here. According to the Stock Traders Almanac, the second year of a presidential cycle (2014) is usually the most dangerous. The historical tendency is for the midterm election year to experience a correction (in the 15-20% range) between April and October. That usually leads to a major buying opportunity which most often leads to a stronger market the following year. I also pointed, however, that January and April were two of the best months to consider taking some profits (or rotate into more defensive sectors). January ends the best "three-month span" of the year that started in November. April ends the "best six-month span" that also starts in November. Of those two months, April is the more significant. Given that scenario, and following this week's market action, it may not be too early to start doing some "re-balancing" away from aggressive stock holdings that had a strong 2013 into more defensive stocks categories that pay dividends and that have lagged behind the market. Those groups include utilities, REITS (and especially homebuilders). That more defensive strategy may become more urgent if the market holds up through April. This may be one year where the "sell in May" strategy carries a lot more meaning.