The 2 Sectors I Have My Eye On Right Now…

With schools closed, many parents are doing their best to manage online education. It sounds simple enough. The goal is to get the child in front of a computer. But the task quickly becomes surprisingly complex. There are siblings’ schedules to consider… parents’ work requirements… plus the dozens of other factors that come with managing a quarantined household.

Running a household in this environment is a challenge. Many investors know this. But when it comes to understanding how the stock market is running, they seem to ignore the fact that there are second order and higher effects to consider.

During the last week of March, investors were celebrating big gains in the stock market. The Dow Jones Industrial Average gained 12.8%, and the small-cap Russell 2000 was up 11.7%. Many investors believed that the bear market was over.

Then, last week, the Dow lost 2.7%. and the Russell 200 was off 7.1%. Many believed this was the first retracement (a countertrend move) of the bull market. In bear markets, retracements are brief “up” moves. In bull markets, the retracement is a short down move.

Last week’s declines could be a retracement. Or, the previous week’s up moves could be a retracement. Investors are projecting their desires onto the stock market instead of impartially analyzing the data.

The best thing we can do is look at some data and then reach a conclusion. To start the analysis, let’s look at a second order effect.

The First Sector I’m Watching

We learned that 6.6 million new claims for unemployment insurance were filed. That brings the total number of Americans who filed for unemployment over the past two weeks to 10 million.

Under normal circumstances, that would mean individuals who lost jobs would struggle to pay bills. That would lead to an increase in bad loans and would hurt financial stocks.

This time, unemployment benefits have been increased by $600 a week. That’s equivalent to $15 an hour on top of traditional benefits that replace about half of lost wages. It is possible unemployment benefits could exceed wages for some employees.

This potentially creates a disincentive to work for some, and that could hurt small business that often pay less than $15 an hour.

That’s the second order, or higher effect, that is difficult to analyze.

There is a benefit to higher unemployment benefits. Unemployed workers should be able to cover their bills, at least for the four months when higher benefits are being paid.

There is also a potential problem with the higher benefits since that means businesses might be unable to bring employees back to work when benefits exceed wages. This could lead to higher defaults on business loans.

From an analyst’s perspective, the end result is likely to be same. Financial stocks are likely to suffer from defaults, and they could be the first to turn when the bear market ends. That’s the pattern we have seen in the past.

The relative strength of financials turned sharply higher at the bottom on 2009. This indicator is in a downtrend for now, and it will be important to keep watching it going forward.

The Second Sector I’m Watching

Another important indicator to follow is the price of commodities. This is another higher order effect of economic activity. Commodity prices change ahead of economic conditions since they are the raw inputs into the manufacturing process.

For example, a manufacturer of copper pipes used in construction will order less copper when demand from home builders turns down. This will be months before construction crews are laid off.

The Thomson Reuters/Core Commodity CRB Index is shown in the chart below. This is an index of 19 commodities: aluminum, cocoa, coffee, copper, corn, cotton, crude oil, gold, heating oil, lean hogs, live cattle, natural gas, nickel, orange juice, silver, soybeans, sugar, unleaded gas, and wheat. It reflects demand for industrial metals, energy, agricultural products, and precious metals. Energy accounts for about a third of the index.

Gray bars show recessions. You can see the three-month rate of change at the bottom of the chart.

Commodity prices reflect economic growth. Prices turn down in a recession. In 2008, prices collapsed as the global financial system froze and brought commerce to a standstill. The current situation mirrors that move.

For now, the trend in commodities remains down. I expect the trend to reverse when the economy stops contracting.

Action To Take

That means I will be watching financials and commodities. They are likely to turn up ahead of the economy. For now, investors remain optimistic that the bear market will end quickly. But if you ask me, there’s really no reason to expect that.

As I explained recently, I’m working with my readers to identify trades we can make that will produce income (what I call “bonus dividends“) with the least amount of risk possible. We’ve been pretty successful so far in this effort, and there’s no reason to think that can’t continue — but we’ll need to be confident in our strategy and not reach for trades.

As I said last week, these are dangerous times for investors and traders. But the benefits can outweigh the risks. If you want to know more about the “bonus dividend” strategy we’re using to earn income in this market, check out this report.