STOCKS HAVE ANOTHER UP WEEK BUT END QUIETLY -- - SURGE IN BOND YIELDS WAS WEEK'S BIGGEST STORY -- INFLATION-SENSITIVE STOCKS SURGED WHILE RATE-SENSITIVE STOCKS TUMBLED -- THAT SUGGESTS THERE MAY BE SOME HEDGING AGAINST FUTURE INFLATION GOING ON
SANTA CLAUS RALLY STILL LIES AHEAD... The stock market experienced the second slowest trading day of the year on Friday as traders headed home for Christmas. All major stock indexes, however, hit new records during the week. The Russell 2000 Small Cap Index had the week's biggest percentage gain but fell just shy of a new record. Passage of the tax reform package helped lift economically-sensitive stock groups like energy, materials, industrials, consumer cyclicals, financials, and transports which outperformed the S&P 500. Rate sensitive utilities and REITs saw the biggest losses resulting from falling bond prices. Consumer staples and healthcare also lagged behind. The biggest story of the week was the surge in the 10-Year Treasury Bond yield to a nine-month high as shown in Chart 1. That was most likely a delayed reaction to the tax reform package. Foreign yields also jumped during the week. Rising yields are consistent with rising optimism on the economy which explains investor buying of economically-sensitive stock groups and selling of more defensive stocks. Although stocks may be suffering from "tax reform fatigue", they should end the year on a firm note. That's because of the traditional Santa Claus rally which usually occurs during the last five trading days of December and the first two in January. And it occurs 75% of the time.
(click to view a live version of this chart)
Chart 1
ARE STOCKS SENDING AN INFLATIONARY MESSAGE?... There may be another stock rotation going on beneath the surface which may also support the jump in bond yields. And that's recent buying of inflation-sensitive energy and material stocks and the simultaneous selling of inflation-resistant stock groups like utilities. A lot of explanations have been given for this past week's surge in bond yields. One that's been left out is the threat of rising inflation in the coming year. Economists see no sign of rising inflation (more on that shortly). But some people do. My Thursday message showed fixed income investors buying Treasury Inflation Protected Securities (TIPS) over the last six months, which is one way to hedge against rising inflation. During those same six months, commodity traders have pushed the price of crude oil up nearly 40%. Base metals have gained 27% this year with the price of copper nearing another three-year high. Those higher prices are being reflected in the buying of their respective stock groups which are starting to show market leadership. At the same time, they're selling bond proxies like utilities. Take a look at the next chart.
Chart 2
THE ROTATION OUT OF UTILITIES INTO ENERGY STARTED IN SEPTEMBER ... The three lines in Chart 2 plot relative strength ratios of materials (blue line), energy (green line), and utilities (red line) versus the S&P 500 (flat black line). The relative strength ratio of material stocks (blue line) started rising during August. It rose sharply again this past week. [It's been driven higher by aluminum, copper, and steel shares]. The ratio for the Energy SPDR (green line) started rising during September and also jumped sharply this past week. Meanwhile, the relative strength ratio for the Utilities SPDR (red line) plunged during September and again more noticeably this week. Notice in particular that the utilities ratio started falling at the start of September just as the energy ratio started rising (and bond yields turned sharply higher). The same thing happened this past week with energy (and materials) being this week's strongest sectors, while utilities were the weakest (as yields jumped). Chart 2 suggests a strong inverse correlation exists between rising energy (and materials) shares and falling utilities. Buying commodity shares and selling rate-sensitive stocks would be another way to hedge against rising inflation (in addition to buying TIPS). And some investors appear to be doing just that. Chart 3 plots a relative strength ratio of the Energy SPDR (XLE) divided by the Utilities SPDR (XLU). The ratio surged to the highest level in nine-months this past week. Bond proxies like utilities usually drop with bond prices when yields rise. But the fact that investors are also buying commodity-related shares suggests that there may also be an inflationary element behind this week's big jump in bond yields. But don't ask an economist about that.
(click to view a live version of this chart)
Chart 3
FED'S PREFERRED INFLATION GAUGE HITS EIGHT-MONTH HIGH... The Commerce Department reported on Friday that the price index for personal consumption expenditures (the measure preferred by the Fed) jumped +0.2% during November which was up +1.8% from a year ago. That was the highest reading in eight months and closer to the Fed's inflation target of 2%. But you probably didn't hear or read that. That's because it was widely reported in the financial media that core inflation (excluding food and energy) rose only +0.1% for a yearly gain of only +1.5%. So no sign of inflation. And that lower inflation number was used to explain why bond prices bounced a bit on Friday. Why do they keep doing that? If energy prices don't matter, why even include them in headline inflation numbers. If they do matter, why do economists keep removing them? Don't people still have to pay those higher gasoline and heating oil prices? And isn't that what inflation gauges are meant to reflect? Wouldn't it be nice if we could all use a "core inflation budget" every month that excludes rising food and energy costs. Maybe economists do that.
HAVE A VERY MERRY CHRISTMAS... Santa's been very good to us this year stockwise. And he may not be finished. He usually visits Wall Street during the last week of the year. So we all have to be good for another week. On that cheerful note, I'd take to take this opportunity to wish everyone (even economists) a very Merry Christmas.
