Blame it on Inflation

With the first half of the year now under our belts, it’s a good time to review which sectors have led the market higher… and which are acting more like dead weight.

The S&P 500, with SPY as our proxy, is up 13.2% year-to-date. That’s the white line in the bottom half of the chart below. Consider this the benchmark.

Since the start of the year, the healthcare (XLV), consumer discretionary (XLY) and financial (XLF) sectors have led the market higher. These sectors have each gained about 19% so far this year.

On the other end of the spectrum, utilities (XLU) and basic materials (XLB) stocks have lagged the broad market. These are up just 6.4% and 2.4%, respectively.

And you can blame inflation for that.

See larger image

While the long-term trend in inflation is down (read: deflation), we’ve seen a near-term rise in inflation over the past two months.

The top half of the chart above shows my real-time inflation indicator. I’ve written on this before, but to recap, it’s a ratio of industrial metal and bond prices. When the ratio is declining… it indicates deflation, or disinflation. A rising line shows inflationary pressure.

As you can see, this inflation indicator has been climbing higher since the beginning of May. Interestingly, the utility sector peaked at the very same time.

Utilities stocks tend to do poorly when inflation is rising. That’s because commodities and debt – on which utilities are heavily dependent – typically become more expensive during inflationary periods. And that puts utility stocks at a disadvantage relative to stocks in other sectors.

That’s why I’m steering clear of this sector until I see near-term inflationary pressure easing. The same goes for basic materials stocks.

Over the next month or so we’ll get a better idea whether this inflationary trend will last or not. In the meantime, stay away from the utility and basic materials (commodity) sectors.