Stock Rotation Could Signal More Gains

Weakness in cyclicals plus strength in growth stocks inspire optimism on a relatively quiet day.
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The major averages finished with modest gains on Thursday, although beneath the surface were the makings of a major rotation. Basic materials producers and cyclical industrial manufacturers lost, while financial and consumer-oriented sellers gained.

News that China had increased interest rates for the first time in nine years had commodities tumbling. Lower oil prices and better earnings reports helped other sectors.

The

Dow Jones Industrial Average

, for example, finished up 2.5 points to 10,004.54, masking the fact that half of the stocks in the index moved 1% or more.

Alcoa

(AA) - Get Report

, down 3% to $32.41, and

Caterpillar

(CAT) - Get Report

, down 2% to $79.53, led the losers, while

AIG

(AIG) - Get Report

, up 2% to $61.21,

General Motors

(GM) - Get Report

, up 2% to $38.81, and

Citigroup

(C) - Get Report

, up 2% to $44.26, were among the top gainers.

The

S&P 500

gained 0.2% to 1127.44 and the

Nasdaq Composite

finished up 0.3% to 1975.74. In terms of industries, the retailers, airlines and parts of the tech sector rose while coal, steel and energy stocks lost.

That shifting beneath the surface could provide a base for further rallying, according to Kevin Marder at Ladenburg Thalmann. "Rotation out of late cyclical groups" supports a bullish case because "most durable market advances need growth stock leadership."

Modest expectations also are setting the market up for an advance in 2005, according to David Ritter at Argus Research. Most third-quarter earnings reports have been slightly ahead of forecasts, he noted. That means next year's estimates "look increasingly reasonable, potentially setting the stage for earnings surprises and solid market performance next year," he wrote. The firm's target for the S&P 500 is 1250, or an 11% gain, for 2005.

In Asia, China appears to be getting more serious about slowing its economy. Months after imposing "administrative measures" that had little effect, the country's central bank raised its benchmark one-year lending rate by 0.27 percentage points to 5.58%.

This follows on the heels of the third-quarter GDP report showing China's economy still expanding at a 9.1% clip and inflation was running at 5.2%. As Chinese demand has been essential in pushing up prices of all manner of commodities, the rate-hike news has sent a shiver through those markets and related stocks.

Phelps Dodge

(PD) - Get Report

and

BHP Billiton

(BHP) - Get Report

each lost 4%.

Bonds were unsteady but changed little on the weakness in oil and commodities. The yield on the 10-year Treasury note rose as high as 4.12% but ended slightly lower on the day at 4.08% vs. the 4.09% level it stood at after Wednesday's selloff.

White Rabbits and Bond Traders

In the somewhat

Alice in Wonderland

bond market view of recent weeks, higher oil will slow the economy so much that the

Federal Reserve

won't hike rates much and yet inflation still will remain vanquished. With oil now falling, that investment scenario is fading.

Speaking of Alice in Wonderland and the bond market, Bill Gross, who runs the $76 billion

(PTTAX) - Get Report

Pimco Total Return fund, posted a new commentary on the firm's Web site on Thursday. Not surprisingly, he's still bearish on bonds and fond of quoting literature.

Thursday's piece was topped with the following quote from Lewis Carroll's

Through the Looking Glass

: "Things are never what they seem, skim milk masquerades as cream."

That was the Grossian way of signaling that more inflation is coming while the Fed remains unwilling to raise rates enough to keep prices stable. "Too much debt in a finance-based economy precludes raising interest rates like we have in the past and while that keeps the patient/economy breathing, it leads to asset bubbles, potential inflation and declining currency over time," he wrote.

Gross is recommending Treasury Inflation Protected Securities, or TIPS, which pay a fixed rate of interest plus the change in the consumer price index. Although he didn't mention it, there's even a TIPS exchange-traded fund run by Barclays called the

iShares Lehman TIPS Bond Fund

(TIP) - Get Report

.

When big pension funds, endowments or insurance companies want to hire a bond fund manager, they almost always choose Gross' firm or one of its two big competitors. Western Asset Management in Pasadena and owned by Legg Mason is the

other

Southern California bond giant (Pimco is in Newport Beach, south of L.A.)., and BlackRock is the New York fixed income shop run by Larry Fink, who is as Manhattan-high-strung as Gross is California mellow.

Interestingly, all three are pretty down on the market's view as seen in the low 10-year yield.

"Market pricing, however, affords investors no protection against inflation remaining at year-to-date levels, and most sensitive indicators continue to reflect that monetary policy has an inflationary bias," wrote Scott Grannis, Western Asset's director of research. "Caution and defensive strategies are thus warranted."

BlackRock is less chatty about its outlook, but in an unsigned commentary posted two weeks ago, the firm was more sanguine about inflation than its two peers. At the same time, BlackRock too was down on the low-yielding market view.

"A neutral fed funds rate would appear to be in the 3% to 4% range," the firm said. "In the short run, bonds are in a trading range, with market participants fretting over whether the Fed will pause at 2% to assess the impact of higher energy costs and the increases in rates so far. Our central thesis is that interest rates will continue to rise and the yield curve will flatten."

On Friday, the market will digest the third-quarter gross domestic product report, with indications of the health of consumer demand, business spending and inflation. Consensus forecast is for a 4.3% gain. Any surprises that challenge the bond bulls, such as a pickup in inflation, could validate the views of the three big bond shops in a hurry.

As originally published, this story contained an error. Please see

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