Everything's Coming Up Roses

Data support the Fed theory of a slowing economy taming inflation. So why are cyclicals leading?
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Can Ben Bernanke control the weather too? As if on cue, this week's inflation came in soft, while industrial production and housing starts point to some weakening growth -- all making the

Fed

chairman look good, as he's probably uncrossing fingers and breathing a sigh of relief.

But the character of Tuesday and Wednesday's stock market rally might be about more than the Fed's forecast that slowing growth will tame inflation. If investors are so gung-ho about slower growth, why is it that the cyclically sensitive sectors are leading the rally, as opposed to the defensive consumer staples and large-cap names? Traders may be betting on a third-quarter bounce.

"There is one problem with the idea that the rally is feeding into the economy slowing down and giving the Fed room to stop raising interest rates," says James Paulsen, chief investment strategist at Wells Capital Management. "It would be more convincing if the entire composition of the stock rally wasn't cyclical."

These cyclical rallies have been coming since month's end on better-than-expected retail-sales reports, a low four-week moving average for jobless claims, a narrower trade deficit and a 16% increase in second-quarter corporate profits, he says.

Wednesday's rally had all the markings of a bullish growth story.

The

Dow Jones Industrial Average

gained 0.9% to 11,327.12, bringing its two-day gain to over 2%, while the

S&P 500

gained 0.8% to 1295.43, bringing its two-day gains to 2.2%. The

Nasdaq Composite

rallied 1.6% to 2149.54 Wednesday, bringing its two-day gain to 3.9%.

Cyclical leadership was back in force Wednesday, with

Deere

(DE) - Get Report

,

FedEx

(FDX) - Get Report

and

Ingersoll Rand

(IR) - Get Report

each up over 4% on the day.

In addition,

Caterpillar

(CAT) - Get Report

gained 2.52%,

U.S. Steel

(X) - Get Report

added 3.9%, while

Ford

(F) - Get Report

continued its climb -- up another 4.3% Wednesday.

The Morgan Stanley Cyclical Index gained 2.1% Wednesday, while the Morgan Stanley Consumer Index climbed 0.5% to 630.48, an all-time high.

The tech sector picked up some steam as well, as the Philadelphia Semiconductor Index gained 4.3%, while the

Merrill Lynch Semiconductor HOLDRs

(SMH) - Get Report

exchange-traded fund gained 3.1%.

Among Nasdaq's gainers were

Conexant

(CNXT) - Get Report

and

Nvidia

(NVDA) - Get Report

, which gained 8.72% and 7.17%, respectively.

While the indices and many of its components made strong moves Wednesday, the rally still lacks strong volume and homogenous behavior within sectors that would characterize real "conviction in the buying," says Louise Yamada, of Louise Yamada Technical Research Advisors. That said, two of the major indices closed above key resistance levels, says Yamada, adding this could mean a retest of the year's highs.

"This is positive, and maybe these will be exceeded, but you still have to be selective," says Yamada. The S&P 500 broke decidedly beyond prior resistance at 1280, and the Dow ended above 11,250. The Nasdaq needs to break through 2200 to reach past its resistance level, she says.

The growth-driven rally was kicked off by tame inflation data. The Labor Department reported Wednesday the consumer price index was in line with expectations -- a 0.4% headline increase and a 0.2% core increase. Investors were on the edges of their seats hoping that the CPI would confirm Tuesday's lower-than-expected producer price index reading.

But again, below the surface, inflation is not really gone, and the Fed's outline for slowing growth taming inflation remains suspect. For one, a single month of data does not a trend make. The 0.2% increase in core CPI follows four months of 0.3% jumps. And behind the PPI weakness was a sharp increase in core crude prices, which gained 1.3% in July, and is up 34.6% year over year. Unit labor costs are also rising at the fastest pace in about six years.

The fed funds futures market has dropped the odds of a September rate hike to about 16%, but the September hike "will be determined by inflation data between now and then," says Ethan Harris, chief economist at Lehman Brothers. Average hourly earnings and another core CPI reading will be key for the Fed and the markets, he says.

Some large holes loom in the slow growth side of the story, too. The Commerce Department reported Wednesday that housing starts fell 2.5% to 1.795 million, lower than consensus estimates. Starts are down 13.3% on the year, and permits are down 20.8% on the year. But housing starts and permits are still at historically high levels, and a 6.1-month supply of housing is just slightly above the 5.9-month historical average, writes Michael Darda, chief economist at MKM Partners.

By the same token, the Fed reported that industrial production rose by 0.4% in July, compared with 0.9% in the prior month and below expectations for a 0.6% increase. But expectations aside, there is still not much slack in the economy these days. Driving down the manufacturing output was a 5.4% drop in vehicle production. Capacity utilization rose to 82.4% in July after being revised to 82.3% for June -- again, lower than consensus estimates, but still at expansion highs, according to Bank of America.

Even Dallas Fed President Richard Fisher acknowledged upward pressure on wages, and other evidence of inflation in the economy. "We appear, indeed, to be at something of a crossroads in the economy and the conduct of monetary policy," he says.

A crossroads at which, for now, the economy and the Fed seem hand in hand.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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