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23.03.2005 16:04

Rev Shark:

On Cusp of a Trend Change, the Game Plan
3/23/05 8:13 AM ET

"First comes spring and summer, then we have fall and winter, and then we get spring and summer again. There will be growth in the spring." -- Chance the Gardner

"I think what our insightful young friend is saying is that we welcome the inevitable seasons of nature but we're upset by the seasons of our economy." -- Benjamin Rand

-- From the movie "Being There"

The one great certainty in the stock market is change. Trends always end, new ones emerge and the cycle repeats. It is as inevitable as the seasons but investors have great difficulty embracing change. They become frustrated when a cycle of growth ends and one of death and rejuvenation begins.

Investors are now dealing with a transition from one cycle to another. We have been in a rising interest rate environment for a while now but the Federal Reserve accelerated matters with some not-so-subtle language about increased inflationary concerns. Signs of inflation, especially in commodities, have been around for a while and all that the FOMC has done is acknowledge it and make it clear that it will aggressively deal with the problem.

Our job as investors is to recognize the change that is taking place -- the acceleration of inflationary concerns -- and to find ways to deal with it as we wait for the next step in the inevitable cycle to emerge. This isn't a time to do battle and curse what is happening; it is a time to understand the dynamics at work and find ways to deal with them.

The one thing that should be clear is that inflation is not good for the bulls. When inflation and rates rise, bonds start to become a more attractive alternative to investors looking for yield. Individual stocks may find profits squeezed, which can make equities less enticing.

The first thing we need to think about is which stocks tend to do well in inflationary environments. Technology and health care companies that don't carry large inventories are often better performers when prices are rising. They are able to pass along increased costs and aren't squeezed by price increases from suppliers.

I've been talking about the possibility of a rotation into technology and biotechnology for a while now and becoming increasingly confident that it is just a matter of time before those groups start to lead. Increased inflation concerns may be the catalyst that triggers that move.

We have sharp drops this morning in oil, gold and other commodities as the dollar accelerates. Obviously money is shifting from those recent leaders as well as homebuilders and other cyclical plays. The cash needs a place to go and the most logical place is technology stocks that offer good "value." A lot of technology stocks are expensive but there are some interesting "growth at a reasonable price" plays, especially in smaller and secondary stocks.

Biotechnology is a sector that is little affected by inflationary concerns and may be viewed as a safe haven for investors looking to shift some cash. Keep an eye on that group for signs of relative strength.

Most importantly we have to keep an eye on the big picture. All of the major indices are in downtrends now and have technology damage to contend with. The worst thing we can do is look for the trends that accelerated yesterday to suddenly end. This market is not healthy and it is a mistake to think otherwise.

Early action is flat. Overseas markets were slammed. The sharp fall in oil is helping matters but we have inventory numbers that will be carefully watched. We also have CPI, which is particularly important as sensitivity to inflation increases.

Gary B. Smith:

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