Are Stock Sectors Pointing To Stagflation?

Click to enlarge:

The chart above is pretty busy, but if you click on the image, you'll be able to tease apart the 2007 performance of the S&P 500 Index (SPY) and eight sectors within that index: Materials (XLB); Industrials (XLI); Consumer Discretionary (XLY); Consumer Staples (XLP); Energy (XLE); Health Care (XLV); Financial (XLF); and Technology (XLK).

As you can see, Energy has been far and away the strongest sector for the year. This reflects the rising price of oil, which in turn reflects the inflationary impact of a weak dollar. Financials have been the weakest sector, thanks, in part, to mortgage crisis concerns. Interestingly, Consumer Discretionary issues have been weak as well, revealing worries over a slowing economy.

When we look at returns since the July market peak, other interesting patterns emerge. Here are how the sectors have fared over that period:

SPY: -4.98%
XLB: -9.61%
XLI: -5.72%
XLY: -8.76%
XLP: -1.65%
XLE: -3.49%
XLV: -3.17%
XLF: -6.82%
XLK: -4.83%

Notice that the Materials stocks have been the laggard since mid-July, falling over 9%. This likely reflects the impact of the falling dollar, which makes raw materials more expensive. We also see continued weakness in the Consumer Discretionary issues, again speaking to concerns over a weakening economy. Interestingly, the strongest sector has been Consumer Staples, as investors have favored shares perceived as recession-resistant.

Now let's take a different look. My Technical Strength Indicator is an attempt to quantify trending behavior over short and intermediate-term time frames. A number near zero indicates a trendless market; a number that is solidly positive or negative reflects an uptrend or downtrend. Here are my TSI numbers by sector, based on the five most highly weighted stocks within each group:

SPX Overall: +620 Materials (XLB): -120 Industrials (XLI): +180 Consumer Discretionary (XLY): -120 Consumer Staples (XLP): +180 Energy (XLE): +240 Health Care (XLV): +180 Financial (XLF): -20 Technology (XLK): +100

The TSI numbers provide a somewhat shorter term picture of sector performance. Again, we see Consumer Staples and Energy strong (recession concerns, oil price inflation). We also see weakness among Consumer Discretionary and Materials stocks (weak economy, falling dollar).

So what do we have? A falling dollar, inflationary pressures, and fears of a weakening economy. Going into the Fed meeting, stagflation is on the radar.