Cyclicals In Focus


Despite worries related to Hurricane Harvey and North Korea, the Dow Industrials and S&P 500 Index have moved mostly sideways. The economically sensitive Dow Transports, after eroding from July 14 to Aug. 24, have bounced about 3%. The Dow Utilities have moved to all-time highs, helped by a drop in 10-year Treasury yields to the lowest level since November.

We'd like to see a rebound above this summer's all-time highs of 22,182.42 in the Industrials and 9,742.76 in the Transports. Short of that, we'd like to see the Transports and other cyclicals display improved relative strength. For now, our buy lists have 92% to 95% in stocks.

Crucial question

Have bond yields dropped because the economy is likely to slow, or merely because inflation and short-term interest rates are likely to remain low? That is a crucial question for investors, as the bullish argument for U.S. stocks begins with the encouraging profit outlook described in Earnings Review.

If the economy stalls and corporate profits stagnate, low bond yields might not be enough to sustain the bull market in stocks. Defensive groups like utilities and consumer staples could attract interest. But such "low-volatility" groups are already among the most expensive relative to historical norms.

Based on both absolute and relative valuations, most of the best values are found in groups sensitive to economic growth. 

So are most of the best growers. While technology stalwarts like Alphabet ($944; GOOGL), ($968; AMZN), Apple ($163; AAPL), Facebook ($170; FB), and NVIDIA ($166: NVDA) benefit from secular tailwinds, all five could face major cyclical headwinds if consumers cut back.

In health care, our health-care system's ability to pay for $50,000 or $100,000 specialty drugs is hugely important to many of the best growers — and over the medium term that ability depends heavily on the U.S. economy's growth rate.

Cyclical bellwethers

Watch the Transports, homebuilders, automotive and industrial groups, and small stocks. Persistent weakness in these cyclical groups amid flat or falling bond yields would bode poorly.

Conversely, a broad-based rebound to new highs amid flat or falling yields could encourage some "new era" thinking, with projections of modest growth and low interest rates for the foreseeable future. While such "new era" thinking usually ends badly, it could be enough to spark a final melt-up in the averages.

Not every bull market reaches the third and final speculative stage described by Dow Theorists. But enough do to justify some consideration of how this bull market might.

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