THE DOLLAR AND BOND YIELDS HIT NEW
LOWS AS STOCKS TEST TOP OF TRADING RANGE
John Murphy
BOND YIELDS AND STOCKS ARE DIVERGING... Throughout the three-year bear market, stock prices and bond yields have been moving together (which means that bond prices have been rising while stock prices have been falling). Since the start of April, however, bond yields and stocks have been moving in opposite directions (meaning that bond and stock prices have been rallying together). We're not sure if this is just a short-term aberration, or a sign that the bond and stock markets are "re-coupling". We think we'll know pretty soon. Here's why. Chart 1 shows the yield on the 10-year T-note falling to a new low this week (actually the lowest yield in 45 years). That's primarily owing to deflationary PPI and CPI numbers this week. [The Dollar fell to a new low for the same reason]. Normally, this would be bearish for stocks, since it's symptomatic of economic weakness and would siphon money out of stocks and into bonds. So far that hasn't happened. At least not yet. Which brings us to the moment of truth for stocks. The major stock averages have reached the tops of their trading ranges -- and continue to look overbought. If the combined effects of a falling dollar and falling interest rates are going to sabotage the rally attempt in stocks, this is where that should happen. If stocks manage an upside breakout, however, that would suggest to us that some changes might be taking place in the intermarket relationship between the stock market and the dollar and bonds.


Chart 1


Chart 2

DOLLAR FALL STILL HELPING GOLD... The gold market continues to benefit from a falling dollar. The Dollar Index fell sharply on Friday and remains under pressure. That explains why the price of gold keeps rising. In a climate of falling interest rates -- and a falling dollar -- gold thrives. The Fed's battle against deflation means that they're going to either lower rates or keep them from rising. They're also happy to see the dollar fall because they're trying to "reflate" the economy by creating a little inflation. That means the Fed is happy to see the price of gold and other commodities rising. That's the first we've seen that in more than half a century. The next hurdle for gold will be the $360 level.


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UTILITIES AND ENERGY SHARES JUMP... The two strongest market sectors this week were utilities and oil stocks. The Dow Utilities broke through their January highs this week to reach the highest level in eight months. Two of the biggest stock gainers were AES and TXU. Oil service stocks were the biggest gainers in the oil patch. The Oil Service (OSX) Index has broken out to the highest level in ten months. We suspect the new strength in energy shares is tied to the fact that crude oil has bounced off major support near $25. The falling dollar may also be playing a role in the recent move back into oil (and gold) shares. We recently suggested that oil stock leadership was another reason for some caution in the stock market. We also suspect that the rise in utilities is a defensive play.


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HMOS HAVE A STRONG WEEK... Health care stocks also had a strong week -- especially in the hospital group. The Morgan Stanley Health Care Index (HMO) is on the rise again and is moving up to challenge the highs of last summer. Its rising price relative line is also a sign of strength.


Chart 7

VIX IS GETTING PRETTY LOW... The CBOE Volatility Index (VIX) fell to 21 on Friday. That puts this contrary indicator at the lowest level since this time last year when it declined to the 20 level. Normally, readings near 20 are indicative of too much complacency and an over-extended stock market. If you compare the VIX to the chart of the S&P 500, you'll see that moves down to 20 have usually been a prelude to a market correction. Last May was a good example. The good news is that the VIX is still dropping. In order for it to signal an actual market top, it has to start rising. Last spring, for example, the jump in the VIX back over 25 signalled a downturn in stocks. We think it's time to start watching the VIX more closely because it's entered a "danger" zone near 20. Any sign of an upturn from here would be even more dangerous. [The Nasdaq Volatility Index (VXN) is currently trading at the lowest level since 1998].


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May 19, 2003

John J. Murphy, CNBC-TV's technical analyst for many years, and Greg Morris offer money managment and market services at MURPHYMORRIS.COM , email address orders@murphymorris.com .

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