
Apr
The S&P 500 hit its high in March 2000, predicting a recession withinnine months.
MARKET ROTATIONS DURING THE 1920s AND 1930sAs accurate as Dr. Moore’s numbers were in predicting the onset of the 2001recession, intermarket rotations since 2000 have not followed the normalpattern seen in most post–World War II recessions. The main deviation fromthe postwar norm has been the major decoupling of bonds and stocks. Asmentioned, the main reason for this changing relationship is the appearanceof deflationary signs not seen since the 1930s. It begs the obvious question asto whether or not the three markets followed their normal rotation duringthat prior deflationary period. The fact that many recent trends have not beenseen since the 1930s also invites comparisons to that earlier era in order tosee what lessons can be learned about the current environment.
COMMODITIES PEAKED IN 1920Any study of the events of the late 1920s and the early 1930s has to beginwith the turn of events starting in 1920. The decade before the 1920s was
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dominated by the inflationary impact of World War I. In the five years priorto 1920, commodity prices had been rising while bond and stock prices hadbeen weak. Things took a turn for the better starting in 1920. During thatyear, commodity prices peaked and fell sharply until 1921. From 1921 to 1929,commodity prices remained relatively flat. With commodities peaking in1920, bonds should have bottomed—and they did.
BONDS BOTTOM DURING 1920Bond prices bottomed during 1920 at the same time that commodity pricespeaked. The peak in commodities meant that the inflationary spike causedby World War I had ended. After bottoming in 1920, bond prices continuedrising until 1928. This major upturn in bond prices at the start of the 1920sshould have signaled a bottom in stock prices—and it did.
STOCKS BOTTOM DURING 1921Historically, bond prices have acted as a leading indicator for stocks; theytend to form major tops and bottoms ahead of stocks. The lead time can be aslong as a year. This is exactly what happened at the start of the 1920s. Bondsbottomed in 1920 (as commodities peaked). The stock market bottomed in1921, one year after bonds bottomed. The stock market then began a majorclimb that lasted into 1929. For most of the 1920s, weak commodity priceswere accompanied by rising bond and stock prices. Until 1928, the three markets followed their normal disinflationary script. Starting in 1928, however,things took a turn for the worse. Not surprisingly, it started with bonds.
BONDS TURN DOWN IN 1928One of the key intermarket principles is that bonds turn down first at majortops. During the first half of 1928, bond prices started to fall. By the start of1929, bond prices had fallen to the lowest level in two years. For the first timesince the start of the 1920s, bond prices were falling while stock prices wererising. This created a negative divergence between bond and stock prices andprovided an early warning that the stock market advance had entered a dangerous stage. Just how dangerous became clear in 1929 when stock prices
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peaked. By the end of 1929, the stock market had started the biggest drop inits history. During the following three years, stocks lost almost 90 percent oftheir value. From an intermarket perspective, the actions of the two othermarkets—bonds and commodities—are very instructive.
BONDS AND STOCKS DECOUPLEIN 1929—COMMODITIES PLUNGEFrom 1928 to 1929, bond prices were weak while stock prices rose. After thestock market peak during the second half of 1929, stock prices plunged whilebond prices rose. This major decoupling of bonds and stocks lasted for thenext two years. It was caused largely by the action in the third market: commodities. Starting in late 1929, commodity prices (which had remained relatively flat during the 1920s) began another major decline at the same timethat stocks peaked. This plunge in commodity prices turned what had been arelatively benign decade of disinflation into a harmful deflationary era thatlasted for several years. In a deflationary climate, stocks and commoditiesfall together—but bond prices rise. Did the three markets top in their normalsequence from 1928 to 1929? The answer is a qualified “yes.” Bonds clearlypeaked first; however, stocks and commodities peaked at the same time. Thedeflationary trends in the three markets at the end of the 1920s closely parallel their respective trends at the end of the 1990s.
STOCKS AND COMMODITIES BOTTOMTOGETHER IN EARLY 1930SWhen deflation is the main threat, stocks and commodities become closelycorrelated. These two peaked together during 1929; they both bottomed threeyears later. The stock market bottomed around the middle of 1932. Commodities bottomed about half a year later. (It is interesting that even thoughboth markets bottomed closely together, stocks followed their normal pattern of bottoming first.) Both then rose together for several years. In a deflationary climate such as existed during the early 1930s, rising commodityprices are considered a plus for stocks and the economy. A rising stock market suggests that economic trends have also seen their worst. (Industrial production, which had plunged during the years 1929–1932, bottomed along withstocks and commodities in the early 1930s—as did the Consumer and the
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Producer Price Indexes, which had plunged into negative territory duringthose deflationary years.)
REFLATING DURING THE 1930sThere is another comparison that could be made between the battles againstdeflation during the 1930s and the one in 2002. It has to do with the dollar andgold. In Chapter 9, it was stated that a falling dollar in 2002 had given a bigboost to commodity prices and gold in particular. It was thought that the Fedwas using the weaker dollar to boost gold prices in an attempt to reflate theeconomy. A similar move was attempted during the 1930s. Prior to 1930, goldwas convertible into dollars at a fixed rate of $20. In 1933, President Roosevelt halted the conversion of dollars into gold. At the start of 1934, the officialprice of gold was raised to $35 an ounce. The jump in the price of goldresulted in a devaluation of the U.S. dollar. It should be evident, then, thatthe idea of weakening the dollar and raising the price of gold to reflate a deflationary economy is not new. It was tried in the 1930s (see Figure 12.6).
FIGURE 12.6
The official price of gold was raised to $35 during the early 1930s inan attempt to reflate a deflationary economy.
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BOND YIELDS SPIKE UP TEMPORARILY IN 1931Bond yields experienced an upward spike from 2 percent to 6 percent in1931, reaching their highest level in almost seven years. The spike provedshort-lived, however. Yields declined in 1932 and hit new lows in 1934. Theywere to decline for another ten years until the mid-1940s. Because bondprices move inversely to yields, they did exactly the opposite. After rallyingfrom the middle of 1929 through the first half of 1931 (while stocks fell),bond prices experienced a sharp decline that lasted into the end of that year.During the second half of 1931, all three markets (bonds, stocks, and commodities) fell together. At the start of 1932, however, all three markets turnedhigher—led by bonds. Bonds bottomed at the start of 1932, stocks bottomedat mid-year, and commodities bottomed at the end of year. (Here again, thethree markets followed their normal rotational pattern of bonds turning upfirst, stocks second, and commodities last.) 1933 turned out to be a relativelystrong year for stocks and commodities. However, bonds suffered from arotation back into stocks that year as rising commodity prices signaled thatdeflationary forces were lifting, which favored stock investments over bonds.After stalling in 1933, however, bond prices resumed their advance in 1934and rose into the 1940s.
STOCKS AND COMMODITIES COMPLETEBOTTOMS IN EARLY 1940sThe period from 1932 to 1942 is probably best described as a bottomingprocess for stocks and commodities. Both markets rose until 1937 and thendeclined into the early 1940s. Stocks and commodities retraced about half oftheir 1930s gains. In 1942, about midway through the Second World War, theS&P 500 (and commodities) turned up again and advanced throughout therest of that decade. (It was not until 1954, however, that the stock marketexceeded the 1929 highs that had been hit 25 years earlier.) In an effortto keep deflation at bay and to help stimulate the economy, the FederalReserve tried hard to keep U.S. interest rates from rising during the 1940s.With short-term rates close to zero, they resorted to buying large amounts oflong-term Treasury bonds from 1942 to 1951. By 1951, the economy was inrecovery and long-term rates rose accordingly. (In the spring of 2003, withshort-rates again close to zero, there was talk that the Fed might use thesame 1940s strategy of buying Treasuries to keep long-term rates from rising
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in another attempt to fight deflation and stimulate the economy. By thatsummer, however, the Fed appeared to have abandoned that unconventional strategy.)
ROTATING ASSET CLASSES OVER DECADESIt is instructive to track the rotating leadership between bonds, stocks, andcommodities over long periods of time. During the inflationary decade thatincludes World War I, commodities were the strongest of the three markets.During the disinflationary 1920s, the leadership passed to stocks. During thedeflationary 1930s, bonds became the top performing asset. After World WarII, stocks resumed a leadership role that lasted from the 1940s to the 1960s.The inflationary spiral of the 1970s put commodities on center stage again(partially due to the Vietnam War). After commodities peaked in 1980, stocksbecame the top performer for the next two decades (bonds also did well, butnot as well as stocks). The deflationary cycle that started in the late 1990sshifted the leadership away from stocks and back to bonds. This had nothappened in 70 years. History has a way of repeating itself. Sometimes,though, we have to go back a long way to study that history.
LESSONS OF LONG CYCLESIn looking over these long cycles of rotation between bonds, stocks, and commodities, there are lessons to be learned. The most obvious is that each assetclass has its “day in the sun.” Those “days” can last for years—even decades.Let’s study the tricky relationship between stocks and commodities. In theearly stages of a major long-term expansion (as was seen in the 1940s), risingcommodity prices are positive for stocks. A little inflation is a good thing. Itis when commodity prices jump to much higher levels (as they did in the1970s) that a little inflation turns into a big inflation, which is bad for stocks.Rising commodity prices can be good for stocks; soaring commodity pricesare bad. Falling commodity prices can also be good for stocks. Commodityprices peaked in 1920 and 1980 and, in each case, remained relatively flat foryears afterward. Declining (or flat) commodity prices ushered in both eras offalling inflation (or disinflation) that carried stock prices higher during the1920s and the two decades after 1980. Collapsing commodity prices are bad
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for stocks, however. In 1929 and 1998, a collapse in commodity prices to thelowest levels in decades turned a beneficial disinflation into a deflation,which is harmful to the economy and the stock market.
THE KONDRATIEFF WAVENo treatment of long economic cycles can be complete without mentioningthe Kondratieff Wave. This long cycle of economic activity, which lastsapproximately 55 to 60 years, was discovered in the 1920s by Nikolai Kondratieff, a Russian economist. The wave appears to exert a major influenceon stock and commodity prices as well as on interest rates. Kondratiefftracked his long wave from 1789 and showed three major peaks, the last oneoccurring in 1920. I described the Kondratieff Wave in my 1986 book, Technical Analysis of the Futures Markets, with the following quote: “The Kondratieff cycle has become a popular subject of discussion in recent years,primarily owing to the fact that its last top occurred in the 1920s, placing itsnext major top sometime in the 1980s.” A decade after the writing of thesewords, the full implications of this top would be felt.Figure 12.7 (courtesy of Topline Investment Graphics) shows the Kondratieff Wave back to 1789. It tracks four long waves during the past twohundred years. The four peaks occurred in 1816, 1864, 1920, and 1980. Each ofthese four economic expansions led to a burst of inflation (characterized by rising commodity prices and rising interest rates). Interestingly, all four of theseinflations roughly coincided with major American wars (the War of 1812, theCivil War, World War I, and the Vietnam War). Each burst of inflation is followed by a peak in commodity prices. (The last two peaks occurred in 1920and 1980.) After peaking, commodities usually plateau for a decade or longer.During this plateau period (which we call disinflation), stock prices do especially well. That occurred during the 1920s and the period from 1980 to 2000.The danger point in the long cycle comes when commodity prices endtheir plateau period and start falling again. This is when deflationary forcesstart to exert their negative influence on the stock market and the economy.(This is what happened in 1929 and 1998.) The chart shows the major peaks instocks that took place in 1835, 1874, 1929, and 2000. The average time betweenthese peaks is 55 years (although the time between the 1929 and 2000 peaks isan unusually long 71 years). The chart also shows that interest rates follow thetrend of inflation or deflation. The plunge in bond yields since 1980 is matchedby a similar decline that lasted from 1920 to 1945. When the long cycle turns
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down (as it appears to have done around 2000), falling rates become a symptom of economic weakness and do not provide much help to the stock market.One of the messages that comes from studying these long cycles is thatthe contraction part of the Kondratieff Wave can last for long periods oftime—even as long as a decade or more. This possibility should dampenexpectations of an early return to the “good old days” that characterized thelast two decades of the twentieth century.
DIVIDING A LIFETIME CYCLE INTO FOUR SEASONSThe notations in Figure 12.7 are the work of Ian Gordon (Vice President ofCanaccord Capital Corp., Vancouver, Canada) who has written a newslettersince 1998 entitled The Long Wave Analyst. Gordon divides the Long Waveinto four parts, which he compares to the four seasons of the year. Each sea-
FIGURE 12.7
The Kondratieff Wave back to 1789 shows four long waves.
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son lasts approximately a quarter of the wave’s entire length (about 15 years).These seasons are superimposed over the Kondratieff Wave in Figure 12.7.The spring season (which Gordon puts at 1949 to 1966) is characterized by astrengthening economy and benign inflation when stocks do well. Summer(which he puts from 1966 to 1980) is an inflationary period and is marked byrising commodity, gold, and real estate values. Autumn (which Gordon saysstarted in 1980) sees the greatest speculation in bonds, stocks, and realestate. This speculative era also sees a massive buildup of debt. Gordon putsthe start of the Kondratieff winter in 2000. The main characteristic of theeconomic winter (marked by a collapse in commodity prices) is deflation,which is made worse by the need to repay all of the debt built up during theautumn period. Stock prices plunge (as do real estate values) during the winter season of the long cycle. The two best defenses are cash and gold.Because its length is approximately 60 years, Gordon describes the Kondratieff Wave as a lifetime cycle because most people live through it onlyonce. This explains why each generation is unprepared for its onset—andunfamiliar with its solutions. People have never seen it before. Because eachbear market is a mirror image of the preceding bull market, the “hangover”after the speculative “party” can go on for a very long time. After all the debthas been repaid, and confidence slowly restored, the spring season starts thelong cycle all over again.
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C H A P T E R 13
The Impactof the Business Cycleon Market Sectors
SECTOR ROTATION WITHIN THE BUSINESS CYCLEThe previous chapter showed how the business cycle has a major impact onthe relationship between bonds, stocks, and commodities (and also how theposition of these three markets tells us something about the position of the business cycle). This chapter shows how the business cycle impacts sector rotations within the stock market. There are two goals here. One is to show thatdifferent market sectors do better at different stages of the business cycle. Bytracking the business cycle, one is able to anticipate which sectors will givethe trader the “most bang for the buck” at any given time. The second goal isto show that sector rotations follow a repetitive pattern where money flowsfrom one sector to another as the economy goes from expansion to contraction and back to expansion. By studying which sectors are leading the overallstock market at any given time, the trader can also make a more reasonableestimate as to where exactly the business cycle is. In this sense, the study ofsector rotation can also play a role in economic forecasting.
SECTOR ROTATION IN 2000 FAVORED CONTRACTIONThe subject of sector rotation within the business cycle was introduced inChapter 7, which covered the stock market topping process during 2000.That chapter showed how sector rotations during that year signaled the endof the economic expansion of the 1990s and the start of an economic con-
199
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traction. Figure 7.10 tracked the rotating leadership among market sectorsthrough one complete economic cycle. Chapter 7 also discussed how Energystock leadership (which occurred in 1999) usually takes place near the endof an economic expansion, and how rotation to Consumer Staples (whichtook place in the spring of 2000) signals the start of an economic contraction. Chapter 7 also shows that the four top sectors during the first 10months of 2000 were Energy, Consumer Staples, Utilities, and Financials.The rotational leadership from the Energy sector into these three defensive sectors that started during the spring of 2000 followed the exactsequence that takes place when the economy moves from expansion to contraction. It took the economic world until the following spring to come tothis realization, however.
ANOTHER VIEW OF THE ECONOMIC CYCLE
MIDDLE EXPANSION
NSIOAN
Transportation
BasicMaterials
Technology
Energy
L ATE
ConsumerCyclicals
NCO
Financials
ConsumerStaples
X PA N SIO N
CapitalGoods
LATE E
EARLYEXP
Figure 13.1 is another version of the sector rotation diagram shown earlier(and is also based on Sam Stovall’s Standard & Poor’s Guide to Sector Investing). Figure 13.1 plots one complete economic cycle in the form of a circle.Starting from the lower left, the economy moves from Late Contraction toEarly Expansion to Middle Expansion to Late Expansion to Early Contraction.Each stage is marked by leadership in one or two stock market sectors.
TRAC
TI
ON
UtilitiesC TIE A R LY CONTRA
FIGURE 13.1
ON
Technology and transportation leadershipduring 2003 fits Early Expansion phase.
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The far right of Stovall’s circle shows that the transition from the LateExpansion phase of the economic cycle to the Early Contraction phaseis identified by rotation from Energy to Consumer Staples and Utilities. Thetransition to the Late Contraction phase shows that money then flows toFinancials. All of these rotations took place in the proper order during 2000and properly anticipated the downturn in the business cycle. Our attentionin this chapter is on the possible transition taking place in 2003 from the LateContraction to Early Expansion phase of the cycle.
SECTOR ROTATIONS DURING 2003SUGGEST EARLY EXPANSIONFigure 13.1 indicates that the two sectors that show market dominance as theeconomic cycle moves from Late Contraction to Early Expansion are Consumer Cyclicals and Technology. The diagram tells us two things. If the economy is starting to strengthen in the spring of 2003, these are the two marketsectors that should assume a leadership role in the stock market. This information tells traders where to concentrate their funds—if they believe that theeconomy is starting to improve. Approaching it from the other direction, signsof leadership in these two sectors (based on relative strength analysis) tell usthat the economy is indeed strengthening. Fortunately, we have technicaltools to help us to determine in which direction market leadership is heading.
SECTOR LEADERSHIP MOVESTO CONSUMERS AND TECHNOLOGYFigure 13.2 is a bar chart that compares the relative performing of the nineSector SPDRs (traded on the AMEX) during the first six months of 2003compared to the S&P 500. Those sectors above the horizontal line (0.0 percent) are outperforming the S&P 500. This is what is desirable—relativestrength and market leadership. The only four sectors that are doing betterthan the S&P 500 during the first half of 2003 are (starting from the right)Financials, Utilities, Technology, and Consumer Discretionary (which is alsocalled Consumer Cyclicals). If one consults Stovall’s circle, it is evident thatthese are supposed to be the top four sectors as the economy goes throughthe transition from Late Contraction to Early Expansion.Another positive sign is that Consumer Staples are the weakest of thenine sectors thus far in 2003. It is normally a sign of increasing consumer con-
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31 December 2002 - 16 June 200310.0%ConsumerDiscr. SPDRUtilitiesSPDR
TechnologySPDR
+6.71 %
+2.82 %
+3.92 %-1.23 %
-6.26 %
-3.28 %
-10.72 %
5.0%FinancialsSPDR
+3.12 %
0.0%
-1.10 %Health CareSPDR
IndustrialsSPDREnergySPDR
-5.0%
MaterialsSPDR
-10.0%ConsumerStaples SPDR
© StockCharts.com 2003
FIGURE 13.2
Leadership by financials, utilities, technology and consumer discretionarysectors during the first half of 2003 hints at a move into Early Expansion phaseof the economic cycle.
fidence when the defensive Consumer Staples are lagging behind (as they aredoing here). During the first half of 2000, Consumer Staples became the topperforming sector. This reflected a loss of confidence in the stock market andthe economy in 2000. Their relative weakness in 2003 is sending a more confident message. (We will come back to this point later in the chapter when wecompare the relative performance of Consumer Staples and economically sensitive Cyclical stocks in 2003.) Another sign of confidence is the fact that Consumer Discretionary stocks are in the top spot during the first half of 2003.
RELATIVE STRENGTH OF CONSUMER SPENDINGFigure 13.3 shows the Consumer Discretionary Select SDPR turning sharplyhigher in March 2003 (when the entire stock market started moving higheras well). As impressive as its rally was during the second quarter of 2003, therising relative strength line along the bottom of the chart is even moreimpressive. This is a ratio (relative strength) line of the Consumer Discretionary SPDR divided by the S&P 500. The rising line shows the group outperforming the S&P 500 since its March bottom.
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29.0
Consumer Discretionary Select Sector SPDRMoving Average (200 days)
28.027.026.025.024.023.022.021.020.00.029
Consumer Discr SPDR / S&P 500 RatioEMA(20)
0.0280.0270.026© StockCharts.com 2003
Aug
Sep
FIGURE 13.3
Oct
Nov
Dec
Feb
Mar
Apr
May
Jun
0.025
Jul
This sector bottomed during March 2003 and started to outperform theS&P 500.
The Consumer Discretionary group includes stocks that sell products(or offer services) that consumers do not necessarily need (like consumerstaples), but that they want. The fact that consumers are willing to spendmoney on discretionary items shows increasing confidence in the economy.Stocks that are included in the group are auto-related, entertainment, homeappliances, homebuilders, restaurants, and retailers. The retailing stocksplay a prominent role in the group. An upturn in retail stocks is considereda sign of confidence.
RETAIL BUYINGFigure 13.4 shows the S&P Retailing Industry Group Index rallying sharplystarting in March 2003. The chart also shows that the March 2003 bottom wasa successful retest of the prior low of September 2001. The line along the bottom of the chart is a ratio of the Retail Industry Group Index divided by theS&P 500. The ratio line bottomed in September 2001 and again in January2003. This meant that retail stocks were moving up faster than the rest of thestock market; another sign that consumers have turned more confident about
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S&P 500 Retailing Industry Group IndexMoving Average (200)
360.0340.0320.0300.0280.0260.0
SP 500 Retailing / S&P 500 RatioEMA(20)
0.3500.3250.3000.275© StockCharts.com 2003
A
S O
N D
FIGURE 13.4
F M A
M
J
J
A
S O
N D
F M A M J
0.250
J
This sector bottomed during March 2003, but started to outperformthe S&P in January.
the stock market and the economy. Consumer spending accounts for twothirds of the economy.Homebuilders have been one of the most resilient market groups throughout the bear market in stocks and the economic downturn after 2000. Thisprobably has less to do with confidence in the economy than it does withrecord-low interest rates. Homebuilders are examined in more detail in the nextchapter. After Consumer Cyclicals start doing better than the rest of the