Volatility and Uncertainty Continue to be the Theme
By Chris Puplava, June 14, 2006
Since Bernanke took the helm from Alan Greenspan he has been flip-flopping back and forth from hawk to dove. He began hawkish, reversed course back in April, and has become hawkish once again. Many commentators point out that Bernanke is "between a rock and a hard place" with the effects of interest rates and the economy and stock market. If he continues to raise interest rates he would crush an already slowing housing market, but if he finishes this rate cycle, the dollar stands to deteriorate even further.
Bernanke must choose the lesser of two evils: fight inflation and save the dollar, or save the economy and housing market at the risk of rising inflation. It appears that Bernanke is unsure of which to choose based upon his flip-flopping between dove and hawk. The Fed has an excellent track record of going too far as their interest rate raising has a delayed effect on the economy and ends up pushing the economy into a recession and sending the markets into a correction. This tug of war between identities has had a clear impact on the markets as the markets themselves appear to stage a rally that falters and can’tseem to get any legs under it.
To see the Fed's record in action please review my previous article, "Caution is warranted!" back in April. When looking at the previous eight business cycles since 1957, on average the Fed Funds rate peaked four months before the business cycle did and the S&P 500 peaked three and a half months before the peak of the interest rate cycle. My conclusion at the end of the article was that based on the Fed's record of going too far and the anticipatory action of the markets to correct prior to the end of the interest rate cycle coupled with the late stage rate cycle we are in, that "Caution is Warranted."
The graph below shows the current rate cycle plotted with the action of the S&P 500 over the past year and a half.
The S&P 500 corrected twice last year from early March to mid May as well as in September to October, yet continued its march upward as did interest rates. With the S&P 500 historically correcting roughly three and a half months prior to the end of an interest rate cycle, the current correction may be different than the two from last year and follow the S&P's historical pattern of rolling over as we are indeed near the end of the current interest rate cycle. This time may be different than the previous two corrections as the air seems to have changed even globally.
The S&P 500 corrected 7.6% and 6.2% in March and October of last year respectively, while it is currently 7.8% below its May high and appears to be of the same relative magnitude as the previous two corrections. However, this current global correction is almost 19% as seen by the international iShares below. This current correction is greater than the roughly 11% correction in October of last year and the 10% correction last March. The current global correction is approaching twice the magnitude of the previous two and we still haven't found a bottom yet.
Table 1. International iShare Market Corrections
What has also changed in the current environment from last March and October is the U.S. economy, which is clearly slowing from rising interest rates as seen by the charts below. New jobless claims are on the rise, domestic vehicle sales are falling, construction spending has been declining since early 2005, housing starts may have peaked, and the rate of non-farm job growth may have peaked.
Source (Figures 2-6): Econoday.com
With rising interest rates causing a slowdown in housing, net mortgage equity withdrawal has been declining at the same time energy spending has increased.
This is alarming as mortgage equity withdrawal (MEW) is the fuel that has driven GDP in this current economic expansion created by decade low interest rates after the recession in 2001, representing a greater proportion of GDP than at the end of the previous business cycle. As can be seen from the chart below, MEW makes up the bulk of current GDP, evident when MEW is removed from GDP, and has been slowing as of late, and any further slowing would have disastrous consequences on GDP and the economy.
As Bernanke hasn't given the market any real direction, volatility has been increasing, and defensive sectors such as healthcare and consumer staples are benefiting from sector rotation. The healthcare sector benefits from rising volatility as investor fear increases and investors move to defensive positions as seen by the charts below.
Figure 9. Consumer Staples Relative Performance
to the S&P 500 and Volatility Index
Figure 10. Healthcare Sector Relative Performance
to the S&P 500 and Volatility Index
Figure 11. Pharmaceutical Industry Relative Performance
to the S&P 500
Figure 12. Biotechnology Industry Relative Performance
to the S&P 500
What the charts above show is the out-performance of defensive sectors in a bear market as well as in periods of rising volatility. As the current bull market is aging while we are into its fourth year, the interest rate cycle nearing a close and the economy slowing, we could be entering into a period of continued weakness in the markets and economy, and defensive sectors should continue to outperform.
John Murphy, a former technical analyst from CNBC and Chief Technical Analyst of StockCharts.com, pointed out the leadership change in the markets and the move to defensive positions in March before the correction. In his 03.13.2006 Market Message entitled, "Recent Buying of Consumer Staples Suggests a More Defensive Mood," he displayed the following chart and commentary:
CONSUMER STAPLES ARE DEFENSIVE ... Chart 3 is a ten-year look at the S&P 500 (monthly bars) overlaid with the relative strength line for the staples group. You'll see that the consumer staples RS (relative strength) line generally moves in the opposite direction of the S&P 500. Consumer staples were out of favor in the latter stages of the 1990's bull trend. They came back into favor starting in 2000 when the market peaked and stayed in favor until the market bottomed at the end of 2002. Staples have underperformed throughout the S&P 500 bull market that's lasted over three years. That means that a resurgence in the relative performance of the group is an early sign that investors are starting to get defensive.
Figure 13. Chart 3 from John Murphy's Market Message 03.13.2006
An internal vote of confidence is seen in the healthcare sector as insiders have stepped up their buying. This was last seen in late 1999, months prior to the upswing in health care stocks and the topping of equity markets. The S&P 500 Health Care sector reached its low in March of 2000 and had surged 57% by December 2000 on a stand alone basis, advancing from 283.19 to 444.98.
S&P 500 Health Care Sector and S&P 500
Source: BCA Research
When looking at figure 15 below, we can see that on a relative strength basis (S&P 500 Health Care / S&P 500) the S&P 500 Health Care sector reached its low in March 2000 at roughly the same time the S&P 500 peaked and outperformed the broad index throughout the last bear market, and topped at the same time the S&P 500 bottomed in 2002. The recent deterioration in the S&P 500 has also coincided with a surge in the relative strength of the S&P 500 Health Care Sector once more, possibly heralding a turning point in the recent bull market.
Figure 15. S&P 500 Health Care Sector and S&P 500
Not only is their sector rotation currently going on in defensive sector, but also in stock classes. Defensive positioning in the markets can also be seen with the out-performance of the Dow Jones Industrial Average (DJIA), outperforming the S&P 500 in 2006, a trend also pointed out by John Murphy in his 03.22.06 Market Message. The S&P500/DJIA ratio broke through the 50 week moving average in 2000 signaling the coming of the 2000 to 2003 bear market while breaking through the 50 week moving average on the upside signaling the current bull market. In both March and October of last year the S&P500/DJIA ratio held above the 50 week moving average, while that has not been the case in the recent correction.
Figure 14. S&P 500 Relative Strength to DJIA
The breaking of the 50 week moving average raises the concern that this current correction may in fact be the start of the next bear market. Whether we are in a new bear market or a gut-wrenching correction, deferment of capital and positioning ones portfolio in defensive areas appears to be the prudent course until Fed Chairman Bernanke indicates clearly his intention of concluding the current interest rate raising cycle. The markets have already taken a beating, but this may be a prelude if Bernanke wants to add insult to injury by raising rates in June or at least not announcing one-and-done.
Basing his decision on current economic reports seems myopic as interest rate changes take months to work themselves into the economy. Instead of basing current decisions on data showing the effects of interest hikes made months ago, his current decisions should be based on where current rate hikes will be sending the economy months from now. The economic effects of his latest rate hike in May will not be seen in the economy until months from now while it immediately affected the global financial markets. The prudent thing to do would be to at least call a ceasefire and pause to assess where things are with the economy as it is already clearly slowing down, and allow previous rate hikes to work themselves through before pushing the economy over the edge.
Bernanke's wavering at the helm is causing many to bail out of the markets, and what worries me is that Bernanke's indecisiveness or pushing rates too far will cause those still in the markets to jump ship and really send the markets lower and the economy into a recession. It could be that he is deliberately flip-flopping to shake out excess speculation in the markets and to bring down commodities and commodity related stocks to use as evidence that inflation is under control, to give himself credibility to go on pause, or end the string of rate hikes. Everything is up in the air until we know where he is going at the upcoming Fed meeting. Until then, expect uncertainty which should aid to health care sector's relative performance.
The big economic report of the day was the release of May's CPI data. The CPI rose 0.4% in May in line with the consensus, which had expected a 0.4% rise. Core inflation (less food & energy) rose 0.3% last month, slightly above the consensus expectation for a 0.2% rise. Core inflation has been at 0.3% for three months in a row with the year-on-year (YOY) core inflation growth now at 2.4% compared to 2.3% in April. The core CPI rate is also beyond the Fed's idealized 2.0% upper limit for inflation. The overall CPI's YOY growth rate is now 4.2%, nearly twice the rate of the core CPI as energy prices have remained at elevated levels, which was the case last month.
Energy led overall inflation last month, rising 2.4% after a 3.9% jump in April, with gasoline also up sharply, rising 4.9% last month. Overall, energy prices are up 23.6% for 2006 with gasoline up 33.4% YOY. Related to energy, transportation inflation was up 1.5% due to higher fuel costs and commodities were up 0.7%.
Table 2. CPI Data for May
Figure 15. Overall CPI and Core CPI Year-on-Year % Change
Following the release of the data, the federal-funds-futures market priced in a 100% chance that the Federal Reserve will raise its target for overnight rates by 0.25 percentage point to 5.25% following its policy-setting meeting on June 28-29, compared to an 84% chance on Tuesday.
On the broader market for equities, advancing issues outpaced decliners by 17 to 15 on the New York Stock Exchange (NYSE). Up volume was 65% for the NYSE and 67% for the NASDAQ.
Overseas, Japan's Nikkei stock average rose 0.64%. Britain's FTSE 100 fell 0.23%, Germany's DAX index rose 0.26%, and France's CAC-40 dropped 0.05%, and Mexico's Bolsa was up 0.89%.
By sector, energy shares rose the sharpest with the AMEX Energy Spider (XLE) rising 2.57%. The materials sector (XLB) and industrial sector (XLI) has put in strong showings, up 1.32% and .87% respectively. The only falling sectors of the day were utilities (XLU) and financials (XLF), down 0.75% and 0.60% respectively.
Spot gold prices finished down $2.30 an ounce to close at $559.75 an ounce, West Texas Intermediate Crude (WTIC) oil rose $0.65 a barrel to close at $69.21 a barrel, the dollar index shed 0.32 points to close at 86.16, and bonds fell as the yield on the 10-year Treasury note rose to 5.05% from 4.96% yesterday.
Have a pleasant weekend,
© 2006 Chris Puplava