"Economic and Market Pulse Continued" Market WrapUp by Chris Puplava

I wanted to continue from where I left off on 11/23/05 when I was reviewing several economic indicators and the markets. This week has several economic reports with the Institute of Supply and Management’s (ISM) non-manufacturing survey report released on Monday and the International Council of Shopping Centers (ICSC-UBS's) weekly comparable store sales at major retail chains as well as Factory Orders released today. Jobless claims will be released this coming Thursday with the Trade Report and Retail Sales due next week, all potential market moving reports.

The ISM non-manufacturing report survey’s business activity index dropped slightly from 59.0 in October to 58.5 for November. New Orders, employment, inventories, new export orders were up while prices and backlog of orders were down. Currently the business activity index is below the level seen when the market peaked in 2000 as did the index. The business index has been on a downtrend with the peak seen in April 2004.

The same downtrend can also be seen in the ISM Purchasing Managers Index (PMI) seen below where the peak occurred in May 2004 with a smaller peak seen last month.

What should be noted is that we have transitioned from a manufacturing economy to a service economy, where the consumption component of GDP makes up just over 70% of real GDP. It makes sense then that the market would follow the ISM service index (business activity) more closely than the ISM manufacturing index (PMI), as the plunge seen in the PMI in January 2004 did not cause a sell off in the market as the Business Activity index held in a range between 60 and 65.

As both the downtrends in the ISM manufacturing and non-manufacturing index do not point to an encouraging trend, neither does the International Council of Shopping Centers (ICSC-UBS's) weekly comparable store sales report. Retail sales plunged in the December 3rd week with a very sharp 3.1% week-to-week drop and year-on-year growth of 3.5% vs. 5.1% in the prior week. The weak sales report by the ICSC confirms the weakness seen in retail sales, published by the U.S. Department of Commerce. Retail sales appear to be slowing down with a steady decline in year-over-year (YOY) sales growth with 10.3% seen in July through 5.7% seen last month.

Note that the peak in sales of the previous bull market was seen in March 2000 while the S&P 500 peak was seen in August 2000, where the peak in sales foreshadowed the peak in the market seen five months later. In the current bull market, peak sales so far were seen in July as mentioned above followed by three months of consecutive declines. If the recent sales peak is in fact THE peak in sales, and if the sales peak correctly foreshadows the market peak by 5 months, the market is due to peak this month.

Further slowdown in economic expansion can be seen in factory orders when looking at new orders on a relative basis comparing YOY growth, while it is too early to tell whether new orders are peaking in absolute terms. The report is released two months after the month that the data is released, putting December’s release date in February.

The Trade Report is also showing weakness seen in exports with the peak in May 2004 followed by a downtrend. Overlaying exports on a YOY % gain basis with the S&P 500 shows a strong positive correlation as well as in absolute terms.

Like factory orders, the release date for the trade report lags the data for the month collected by two months. If the peak was seen in August as exports appear to be rolling over, seen in the graphs above, where the August saw a 12.1% YOY gain followed by September’s sharp fall to 7.7% YOY gain, further slippage seen in next week's trade report for exports would not be good news for the markets.

As the graphs above collectively point to a possible economic slowdown, I would like to conclude as I did in my last article, reviewing where we might be in the stage of the current bull market. Two weeks ago in my last article I mentioned Sam Stovall’s review of the bull markets since 1942 and their yearly performances (click here for link). To summarize his work and what I wrote, the third year poses the biggest challenge to the markets and the third year for the present bull market ended 10/10/05 up 5.8%, 2.8% higher than the third year average seen since 1942 for bull markets.

Momentum in the current bull market appears to be slowing as seen by the chart below from Ron Griess, proprietor for The Chart store (www.thechartstore.com).

Ron mentions that the trend in the MACD may be breaking through its downtrend seen since late 2004. It is still too early to tell whether the markets are completing a broad top or still have life in them. I mentioned in my last article that Sam Stovall’s analysis showed that of the bull markets that finished the 3rd year on a positive or flat note saw an average of 14% return in the fourth year. Note that of those bull markets that survived the 3rd year on a positive note, their average return in the 3rd year was 11.8%, well above the current markets 5.8% third year return. There still could be a few months left in the current bull market as is supported by Ron’s analysis of copper as an indicator of economic activity.

Ron’s graphs are quite insightful and like he says, “History wants to tell you a story.” The story Ron shows is copper's sensitivity to the business cycle as shown by his charts below.

Ron’s charts show that copper typically has a basing period in the early phase of the business cycle and can have anywhere from one to three peaks in the business cycle. The last peak typically occurs roughly five months into the recession and can range from one to five months, with the peak in the last expansion, March 1991 to November 2001, occurring midway through the prolonged expansion.

As copper is still reaching record highs, the current business expansion may still have some ways to continue, and if that is the case, a review of sector rotation and the market cycle would shed some light on what does well near the end of the life of a mature bull market.

Sector rotation as an investment strategy surfaced from the National Bureau of Economic Research (NBER) data on economic cycles dating back to 1854. NBER provides the time lengths for the business cycle between peaks and troughs. Since 1945, the U.S. economy has gone through 11 recessions and 10 expansions with the present one being the 11^th. Expansions have lasted an average of 57 months with contractions lasting an average of 10 months. The current expansion is in its 49^th month as the beginning was November 2001 according to NBER data.

After Sam Stovall’s review of the economic cycles he suggested that by dividing the NBER cycles into sub-stages, historically successful periods for stocks in certain business sectors become apparent. His work can be found in his book, Sector Investing (1996). He points out that by “Breaking expansions into early, middle and late phases of equal durations, and recessions into early and late periods of similar lengths, and then analyzing the frequency of the market outperforming the industries in the S&P 500 during these periods, a pattern of sector rotation is apparent….”

A graphical representation of Sam Stovall’s model on sector rotation is given below by Stockcharts.

Based on Sam Stovall’s model, the technology sector leads the market cycle followed by the industrial and basic industry sectors. The energy sector outperforms near the market top while defensive sector rotation is seen with consumer staples outperforming at the beginning of a bear market. The Financial sector does well as do utilities during the middle to late stages of a bear market as these interest rate sensitive sectors benefit from falling interest rates typical of economic recessions.

To test Sam Stovall’s model on sector rotation I have looked at sector exchange traded funds (ETF) to see if the out-performance of sectors occurred during the time portions of the market cycle depicted in the chart above. Stovall’s model shows the technology sector outperforming during the market bottom and into the middle of the bull market. As 10/10/02 marked the last bear market’s bottom and beginning of the current bull market, I graphed the technology sector SPDR (XLK) from October 2002 to April 2004, which would be the middle of the current bull market if 4^th quarter 2005 to 1^st quarter 2006 marks the market's top.

The technology sector as seen by the chart did quite well in the initial stages of the current bull market with its peak occurring in January of 2004 followed by a period of weakness.

Ford Equity Research has a graphing software that applies valuation analysis for stocks and indexes. Their valuation bands help to determine whether a stock or index is under or overvalued. Their software plots a plus and minus two standard deviations band around the mean P/E ratio, which represents the range that the P/E ratio will fall 95% of the time. When the price of a stock/sector/index approached the upper band (overvalued) the stock will likely fall in price unless the earnings increase or price earnings expansion above historical norms occurs.

I applied the Ford Custom Graphs software to their Technology group sector consisting of an average of over 900 stocks with the chart shown below to compare to the technology sector graph (XLK) above.

As seen by the chart above, the technology sector had been traveling at its upper P/E band, which is two standard deviations from its mean, during late 2003 to early 2004. This was a clear warning that the sector was overvalued, and since then corrected until middle 2004 back down to its lower P/E band as the group's average price fell and earnings caught up. The earnings trend since the end of 2004 has been relatively flat for the technology sector which is why it isn’t surprising the sector hasn’t taken off significantly.

Following the technology sector in out performance according to Stovall’s model above is the basic materials sector. Below I have graphed the Materials Select Sector SPDR (XLB).

The materials sector began to perform concurrently with the technology sector in early 2003 with its peak seen in March of 2005, just over a year after the technology sector peaked when looking at the Materials sector SPDR (XLB) above. The Ford Custom Graphs does not have data for the Metals & Mining sector and so valuation analysis wasn’t possible.

Nearing the end of the market cycle the energy sector begins to dominate as the leading sector. Below is the Energy Select Sector SPDR (XLE).

The energy sector began to take off in early 2004; more than a year after the market bottomed and the current bull market began and has even accelerated since May of this year. As the economy began to roll along, the demand for crude oil increased as did the commodity. See chart below.

A valuation analysis of the Amex Natural Gas Index (XNG) and the Amex Oil Index (XOI) reveal several key trends in the energy sector using the Ford Custom Graphs.

As seen by the chart above, the XNG had been traveling along its lower PE band with its earnings trend on a consistent upward trend (see green lines). The XNG first became overvalued in March of 2005 when it touched its upper PE band and corrected back down to the lower band in middle of May. The XNG then rebounded and traveling along the upper band until correcting in October. Note the acceleration in the earnings trend (green lines) occurring in the middle of this year that show no sign of slowing down or peaking. Based on the predictive power of the PE bands, with the XNG trading along its lower PE band a move to the upside following the upward earnings trend seems likely.

The Ford Custom Graph of the XOI shows a similar pattern to the XNG shown below with the PE upper and lower two year extremes, 14 and 10 respectively.

The XOI has been traveling along its lower PE band (10), which has like the XNG, accelerated since the middle of 2005. What is interesting is that the XOI was not overvalued in October as the earnings trend had kept up with the price movement. This points to the recent correction as being an overreaction by the markets and not on a fundamental basis of value.

As the charts of the Energy Select Sector SPDR (XLE), crude oil, and the Ford Graphs for the XOI and XNG show, the energy sector is still in a period of out-performance and has not broken through its long term trend lines. In fact, it has even accelerated and continues to be the smart sector play in the current and mature bull market.

The Dow closed today down just under half a percent to 10818.91, a loss of 45.95 points. The NASDAQ was down 8.75 to close at 2252.01 with the S&P 500 also slipped, down 6.33 to 1257.37, with the markets taking a break from overbought conditions from a five week rally. Declining stocks led advancing stocks two to one on the NYSE, with decliners leading advances 1.9 to 1 in the NASDAQ.

In news, the Energy Department released its weekly petroleum data showing a gain of 2.7 million barrels in both crude oil inventories as well as gasoline and distillate inventories. Another easing to the energy concern was an increase in refinery capacity to 90.6%, the first 90%+ reading since the hurricanes of mid-September.

Crude futures closed down 73 cents at $59.21after the bearish inventories numbers. January unleaded-gasoline futures finished down 1.59 cents at $1.5676 a gallon and heating-oil futures lost 3.54 cents to close at $1.7366 a gallon. Natural gas spot prices gained $0.211 to close at $13.70.

Gold spot prices were up $3.10 an ounce as gold approaches nearly $520 an ounce amidst heavy physical demand and inflation fears. The dollar gained from a pullback seen in the euro from an all-time high against the Japanese yen and with two more rate hikes seen on the horizon.

Index	Price	Price Change	Today's % Price Change	Week To Date % Price Change	1 Month % Price Change
Dow Jones Industrial Avg.	10,810.91	-45.95	-0.4%	-0.6%	2.7%
S&P Dep. Receipts	126.08	-0.74	-0.6%	-0.6%	3.2%
Nasdaq Composite Index	2,252.01	-8.75	-0.4%	-0.9%	3.8%
Nasdaq 100 Trust	41.86	-0.08	-0.2%	0.6%	4.4%
Dow Jones Transportation Avg.	4,110.25	-18.24	-0.4%	-0.7%	4.4%
Dow Jones Utility Avg.	401.09	-2.97	-0.7%	-0.5%	2.1%
Inter@ctive Internet Index	177.17	-0.42	-0.2%	-1.0%	3.6%

Description	Last Price	Price Change	Today's % Price Change	Week To Date % Price Change	1 Month % Price Change
Basic Materials	1,291,336	-6,510	-0.5%	0.2%	6.6%
Capital Goods	687,047	-8,304	-1.2%	-1.0%	5.1%
Conglomerates	813,820	-4,328	-0.5%	-0.4%	5.8%
Consumer Cyclical	798,382	-6,803	-0.8%	-1.1%	3.7%
Consumer/Non-Cyclical	1,316,365	-8,110	-0.6%	-0.9%	1.0%
Energy	2,649,323	-15,540	-0.6%	0.6%	4.2%
Financial	4,932,533	-41,941	-0.8%	-0.6%	3.6%
Healthcare	2,285,481	-7,765	-0.3%	-1.1%	0.6%
Services	4,478,106	-4,622	-0.1%	-0.4%	2.0%
Technology	3,181,904	-11,432	-0.4%	-0.7%	4.9%
Transportation	392,756	-1,253	-0.3%	-0.3%	4.9%
Utilities	880,824	-6,644	-0.7%	-0.4%	2.7%