By December of 2002, however, the Dollar Indexwas breaking a rising seven-year-old trendline, as shown in Figure 9.11. Inchart work, this is a serious breakdown and is indicative of the start of amajor decline in the U.S. currency. At the same time that the dollar wasbreaking down, the price of gold was breaking out of a sideways bottomingpattern that had been forming for five years (see Figure 9.12). Gold had justrisen over the $325 level, which had been the peak toward the end of 1999.The upside breakout signaled the start of major bull market in gold. This is anexample of how to blend traditional chart work with intermarket principles.Both gold and the dollar were experiencing major trend changes at the samepoint in time. And both were moving in opposite directions.
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420.0
Gold - Continuous Contract
400.0380.0360.0GOLD PRICES AND THE DOLLARTREND IN OPPOSITE DIRECTIONS
340.0320.0300.0280.0260.0
© StockCharts.com 2003
1994
1995
FIGURE 9.12
1996
1997
1998
1999
2000
2001
2002
Gold prices were breaking out of a five-year bottoming formation at the endof 2002. The falling dollar helped.
SWING BACK TO HARD ASSETS?Long-term charts suggest that hard assets may be starting a period of outperformance over paper assets. The 1970s were the last period to witnessinvestor preference for commodities (hard assets) over bonds and stocks(paper assets). Since 1980, commodity markets had been in decline whilebonds and stocks had been in major bull markets. Over the last two disinflationary decades, paper assets trounced hard assets. This may be changing,however. As is discussed in the next chapter, a generational shift may be taking place away from paper assets and back to commodity-type investments.
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Shifting from Paperto Hard Assets
GOLD COMES BACK INTO FAVORGold is often used as a proxy for the entire commodity sector. This is probably due to its long history as a store of value and the fact that it is the mostrecognizable of all the commodity markets (with the possible exception ofoil). Radio and television business shows always quote the price of gold, butnot necessarily the price of cotton or soybeans. It is also relatively easy forinvestors to take advantage of gold trends by either buying individual goldshares or putting money into a precious metals mutual fund. Historically, thetrend of gold is tied to trends in the general commodity price level.Gold surged over $700 during the 1970s when commodity markets as agroup were in major uptrends. Gold peaked in 1980 just as the commoditybubble was bursting. It then declined for the next 20 years as commodityprices fell out of favor. Gold also has a history of leading turns in the generalcommodity price level. As a result, what gold does has a major bearing on thedirection of commodity prices and the public’s perception of the attractiveness of commodities as an investment alternative to bonds and stocks. Inaddition, for the first time in 20 years, gold and commodities have beenattracting attention—at the expense of bonds and stocks.
GOLD BREAKS 15-YEAR RESISTANCE LINELong-term charts are the most useful for spotting major trend changes. Thisis true for all markets. When prices break trendlines that have been in exis145
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Gold - Continuous Contract
650.0600.0550.0MAJOR BULLISHBREAKOUT IN GOLD
500.0450.0400.0350.0300.0
© StockCharts.com 2003
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
FIGURE 10.1
Gold breaks a 15-year resistance line.
tence for several years, it is usually an indication that something important ishappening. The previous chapter talked about how the breaking of a sevenyear up trendline by the U.S. dollar near the end of 2002 coincided with a bullish breakout in gold prices. However, this was only part of the intermarketstory. As 2003 was starting, the price of gold had risen to the highest level inover five years. Even more impressive was the fact that bullion had risenabove a fifteen-year trendline extending all the way back to 1987, as shownin Figure 10.1. It was another important chart sign that this latest rally ingold had staying power behind it and was more than just another bear marketrally in a long-term downtrend. Something else happened that gave morecredibility to the upturn in gold: Stocks were peaking.
GOLD TURNS UP AS STOCKS TURN DOWNAs mentioned earlier, there is a historical tendency for gold prices to trend inthe opposite direction of stocks. Gold is considered to be a hedge against afalling stock market. It does not matter if the threat to stocks is comingfrom inflation or deflation. The fact is that gold is tied to the stock market—
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but as an alternative investment. Gold prices peaked in 1980 and were in abear market for nearly 20 years. Stocks bottomed during 1982 and were ina bull market for the same 20 years. In other words, the 20-year bull marketin stocks coincided with a 20-year bear market in gold. It was no accidentthat both of those long-term trends started changing direction between 1999and 2001.Any comparison of the two markets will show that the bull market instocks ended just as the new bull market in gold was starting. Most impressive of all was the fact that the gold market broke its 20-year down trendlineat the same time that stocks broke their 20-year up trendline (see Figure10.2). Taken one at a time, these trend changes looked important. Takentogether, they reinforced each other’s trend reversals. Using traditional charting tools, it could be seen that each market had experienced a major changein trend. From an intermarket perspective, it could also be seen that bothtrend reversals took place at the same time. Most importantly, they were stilltraveling in opposite directions. What was bad for one market (stocks) wasgood for the other (gold). Because gold is a harbinger of trends for othercommodity markets, its major bullish turnaround after 2000 also signaled an
Gold
700.0
GOLD PEAKED IN 1980
600.0AND IS IN A NEW BULL MARKET
500.0400.0300.0
GOLD STARTED TO BOTTOM IN 1999DJIA
12000.010000.08000.06000.0
AND PEAKED AROUND YEAR 2000
4000.0
STOCKS BOTTOMED DURING 1982THE TWENTY-YEARBULL HAS ENDED
2000.0
© StockCharts.com 2003
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
FIGURE 10.2
Gold entered a new bull market during 2002 just as the Dow was ending itstwenty-year uptrend.
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upturn in commodity prices. This indicated a major change in the relationship between stocks and commodities.
COMMODITIES OUTPERFORM STOCKSFOR FIRST TIME IN 20 YEARSGold was not the only commodity that was rising during 2002. As we showedin the previous chapter, the CRB Index (which includes 17 commodity markets) rose to the highest level in five years before the end of the year. Thismade the commodity markets the strongest market group during 2002. Oneof the best ways to compare two asset classes is by using relative strength, orratio, analysis. The ratio divides one market by another. If the ratio line isfalling, it means the numerator is the weaker of the two markets. If the ratioline is rising, the numerator is the stronger market (see Figure 10.3).A ratio of the CRB Index divided by the Dow Jones Industrial Average forthe last twenty years presents a striking picture. (Be sure to use a logarithmic price scale for long-term chart comparisons as opposed to the more tra-
CRB Index / DJIA Ratio
0.3500.3000.2500.2000.150RATIO OF THE CRB INDEXDIVIDED BY THE DOW - FORTHE FIRST TIME IN 20 YEARS,COMMODITIES ARE DOINGBETTER THAN STOCKS
0.100
0.050
© StockCharts.com 2003
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
FIGURE 10.3
The CRB/Dow ratio has broken a long term down trendline. For the first timein twenty years, commodities are doing better than stocks.
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ditional arithmetic scale. The log scale measures percentage changes insteadof absolute changes. Long-term trendline analysis is thus more valid whenapplied to a log scale.) The CRB Index/Dow ratio peaked in 1980 and droppedthroughout the next two decades. It started leveling off between 1999 and2001. During the first half of 2002, however, the ratio line broke the 20-yeardown trendline drawn over the highs of the prior two decades. This upturn inthe CRB/Dow ratio marked a major change in their relationship to eachother. For 20 years, stocks had been the stronger asset class. Now, for thefirst time in two decades, commodities had become the stronger one. Thebreaking of the 20-year down trendline in the CRB/Dow ratio appeared tobe signaling a generational asset allocation shift out of paper assets (likestocks) and into hard assets (like commodities). (There is more on the useof relative strength, or ratio, analysis and its implications for asset allocationstrategies in the next chapter.)
WHY 2003 WAS NOT A REPLAY OF 1991At the start of 2003, the conventional wisdom on Wall Street and in the financial media was that the steep advance in gold was due primarily to theimpending war with Iraq. The same thing had happened during Desert Stormin 1990–1991. In the six months before the earlier conflict, gold rallied whilestocks fell. As soon as the war was resolved, gold prices collapsed and stocksturned back up again. A lot of people expected a replay of those trends during the first quarter of 2003 as the second Iraq conflict drew closer. An examination of long-term charts, however, revealed major differences in the twomarkets in the periods surrounding the two Iraq conflicts (see Figure 10.4).In 1990, gold was in the midst of a long-term bear market. The rally thattook place during the second half of that year was nothing more than a bearmarket bounce. After it ended, gold resumed its downtrend. The situation instocks was exactly the opposite. In 1990, the stock market was only halfwaythrough a long-term bull market. The decline during the second half of thatyear was a relatively minor interruption in the stock market’s long advance.Once the war was resolved at the start of 1991, the stock market rose to recordhighs and resumed its long-term bull market. The situation in both markets in2003 was quite different. Gold had already broken a 20-year resistance line andwas now in a major bull market. Stocks had broken a 20-year support line andwere now in a major bear market. The situations in both markets were exactlythe opposite of what they were in 1990 and 1991. Gold was now in a secularbull market, while stocks were in a secular bear market.
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Gold
700.0GOLD IS NOW IN ANEW BULL MARKET
600.0500.0400.0300.0
THE 1990 BEAR MARKET GOLDBOUNCE PROVED TO BE SHORT-LIVEDDJIA
12000.010000.08000.06000.0
STOCKS WERE IN A SECULARBULL MARKET DURING THE 1990PERSIAN GULF WARSTOCKS ARE NOW INA SECULAR BEAR MARKET
4000.02000.0
© StockCharts.com 2003
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
FIGURE 10.4
Why the 2003 Iraq war wasn't a replay of 1991. In 2003, gold is in a bullmarket while stocks are in a secular bear. Those situations were reversedduring the Persian Gulf War in 1991.
CYCLICAL TRENDS VERSUS SECULARIn order to understand the true meaning of these long-term trend changes, itis necessary to understand the difference between a cyclical trend and a secular trend. The best way to understand this is to study a 20-year chart of thestock market using a logarithmic scale. A 20-year chart of the S&P 500 showsan uptrend starting in 1982 and ending in 2002. A rising trendline can bedrawn under the intervening lows that remained unbroken for 20 years (seeFigure 10.5).A secular bull market is very long-term in nature and can last for decades.The bull market in stocks from 1982 to 2002 was just such a bull market.There were three intervening bear markets, however, during this secularuptrend. These bear markets occurred during 1987, 1990, and 1994. The relatively small declines are referred to as cyclical bear markets. They are generally relatively shallow and do not do any damage to the secular uptrend. Acyclical bear market can be thought of as an interruption in a long-term bull
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S&P 500 Large Cap Index
151
1500.01300.01000.0700.0500.0
300.0
200.0
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
FIGURE 10.5
Cyclical bear markets took place in 1987, 1990, and 1994 duringthe secular bull market in stocks. Stocks are now in a secular bear.
market. During 2002, however, the S&P 500 broke its 20-year rising trendlineand entered a secular bear market, one which would be much different fromthe three prior bear markets. It would be much steeper and last a lot longer.(The last two secular bear markets took place during the 1970s and the1930s.) Bull markets can take place during a secular bear market. However,such bull markets are cyclical in nature. As a result, they tend to be shallower and shorter than cyclical bull markets that take place during a secularbull market.
HISTORICAL RESEARCH ON CYCLICAL BULLSIn a June 16, 2003, interview in Barron’s entitled “Bear’s Pause,” Ned Davis1discussed some of his research on the difference between cyclical and secular trends. Davis divided secular stock market trends lasting 16 to 20 yearsinto three or four shorter cycles (which allows for the traditional four-year1
President of Ned Davis Research, Venice, Florida.
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cycle). He found that cyclical bull markets in secular bear markets “didn’t lastas long as other cyclical bulls and they didn’t go quite as high. . . .” He isolatedseventeen cyclical bulls within secular bear markets and found that the S&P500 gained an average of 50.6 percent and lasted 371 days on average. Davisalso studied four cyclical bull moves that occurred within the Japanese secular bear since 1989. These Japanese cyclical rallies gained 48 percent, 34 percent, 56 percent, and 62 percent; these numbers averaged about 50 percent.
SECULAR BEAR IN STOCKS IS GOOD FOR GOLDWhich brings us back to the relationship between stocks and gold. For twodecades, gold was in a secular bear market, while stocks were in a secularbull market. After 2002, the situation was reversed. Gold had entered a secular bull market and stocks were now in a secular bear market. This meantthat the odds were pretty good that gold (and gold shares) would probably bea much better place to be than stocks for several years to come. The samewas true for commodities. This realization has enormous implications in theasset allocation process. Most people take asset allocation to mean choosingfrom only bonds, stocks, and cash. There are compelling arguments, however, for treating commodities as a separate asset class as well, argumentswhich are presented in the next chapter. If the long-term charts shown in thischapter are telling the true story, commodities may be one of the strongestasset classes for several years to come.
RISING CURRENCY MARKETSCommodities are not the only markets that benefit from a falling dollar. Whenthe U.S. currency is in a major decline, foreign currencies move up. Just as afalling dollar produces higher gold prices, it has the same bullish impact onforeign currencies. That means that a bull market in gold should correspondwith bull markets in other currency markets. This has been the case for thepast two years. A chart comparison of the gold market to the euro, for example, shows them rising together, primarily as a result of the falling dollar. Theeuro starting moving up in earnest during the spring of 2002, just as gold wasrising over $300. By the spring of 2003, the euro was hitting a four-year high asgold exceeded $375 (see Figure 10.6).
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110.0
Euro IndexMoving Average (50 days)Moving Average (200 days)
105.0100.095.090.085.0375.0
Gold - Continuous ContractMoving Average (50 days)Moving Average (200 days)
350.0325.0300.0275.0© StockCharts.com 2003
Apr
Jul
Oct
FIGURE 10.6
Apr
Jul
Oct
Apr
Jul
Oct
The gold market and the euro have been moving up together since 2001.Both uptrends are being caused by a weak dollar.
THE FALLING DOLLAR HURTS GLOBAL MARKETSOver the previous year, the euro had gained 27 percent against the dollar. Bycontrast, the Japanese yen had risen only 8 percent. The smaller rise in theyen was due to intervention by Japanese central bankers to keep theircurrency from rising too fast. In a deflationary economy like Japan’s thatdepends heavily on exports, a rising yen hurts exports and makes deflationworse by keeping prices down. By the spring of 2003, there were growingconcerns that Germany (the biggest economy in Europe) might also be on thebrink of a deflationary recession. With German first quarter economic growthclose to zero, the rising euro was cutting into German exports.A rising euro also had the unwelcome effect of pushing German priceslower, which was potentially deflationary. The rising euro was not so muchsignaling European economic strength as much as it was signaling Americaneconomic weakness. While the falling dollar was intended to help the U.S.economy, it was making things worse everywhere else. Although the fallingU.S. dollar was intended to create a little inflation here at home, it was
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having the opposite effect of creating deflation in other countries by raisingthe value of their currencies.
CHINA NOT AFFECTED BY DOLLAR MOVESOne country that was not negatively impacted by the falling dollar was China.The Chinese currency was informally pegged to the dollar. As a result, thefalling dollar did not hurt the competitive advantage of the Chinese as muchas it hurt Japan and Europe. The continuing supply of Chinese goods on theworld markets was another factor which contributed to the global deflationary trend. The global supply of goods was simply greater than the globaldemand for them. As a result, international pressure was put on the Chinesegovernment in 2003 to revalue their currency in an attempt to level the playing field with other countries in Asia and Europe.
COMMODITY CURRENCIES RALLYAs previously discussed, there are two commodity-based currencies that areclosely tied to the fortunes of commodity markets: the Australian and Canadian dollars. Both countries are big producers of commodities and naturalresources. As a result, they do better when commodity prices are rising. InChapter 5, we compared the Australian dollar to commodity prices to showthem falling together in 1997 and 1998 (in the aftermath of the Asian currencycrisis), then rising together in 1999. During the first half of 2002, commodityprices had rebounded from prior lows formed at the start of 1999 and startedto move higher. Not surprisingly, the Australian and Canadian dollars beganimpressive bull runs of their own. Part of their rise was due to the fall in theU.S. dollar. But it also had a lot to do with rising commodity prices as shownin Figures 10.7 and 10.8. Relatively high interest rates in Australia and Canadaresulted in high-yield currencies that attracted foreign capital. Their relatively high interest rates were due largely to rising commodity prices.
USING THE FUTURES MARKETSWhen one talks about commodity markets and foreign currencies, the discussion is primarily about futures markets. Futures markets provide a built-inasset allocation model that encompasses bonds, stocks, commodities, and
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© StockCharts.com 2003
Canadian Dollar Index
75.072.570.067.565.062.5
Industrial Metal Prices - Goldman Sachs Commodity Index
190.0180.0170.0160.0150.0140.0130.0A
J
O
FIGURE 10.7
A
J
O
A
J
O
A
J
O
A
J
O
A
J
O
The Canadian dollar is closely linked to commodity prices.
Industrial Metal Prices - Goldman Sachs Commodity Index
190.0180.0170.0160.0150.0140.0130.0Australian Dollar
80.075.070.065.060.055.050.0
FIGURE 10.8
The Australian dollar is also closely linked to commodity prices.
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currencies. Futures traders have an enormous edge in this regard, and havea number of ways to take advantage of intermarket opportunities. They caneasily switch funds among the four futures groups. Switching from bonds tostocks—or from stocks to commodities or currencies—is a simple task. Allof these markets have actively-traded futures contracts. Within the commodity markets, traders can buy individual commodities like gold or oil.Alternatively, they can buy and sell baskets of commodities. Futures contracts exist for the CRB Index and the Goldman Sachs Commodity Index.Futures traders also have the advantage of trading from both the long andshort side of markets. This means that they can profit from bull and bearmarkets. Of course, futures trading is a risky business and certainly is notfor everyone. The next chapter, however, explores more fully a possible rolefor the futures markets in the asset allocation process without having to buyor sell individual commodity or futures contracts. I am referring here to managed futures accounts which are similar to stock mutual funds; the differenceis that they deal in futures markets.
NOT A LOT OF ALTERNATIVES IN TRADITIONAL MARKETSIf the long-term charts are right, stocks should produce subpar returns forseveral years. With long-term interest rates at forty-year lows, upside potential in the bond market also appears limited. Historically low short-term interest rates make money market funds relatively unattractive. If investors arelooking for growth over the next several years, they may have to start looking outside of the traditional bond and stock markets. Commodities and currencies are two areas where most of the growth potential may lie.
BUYING COMMODITY-RELATED STOCKSIt is possible to take advantage of rising commodities without having to actually buy the commodities themselves. Many stock market sectors and industry groups are tied to commodity markets. Gold stocks are an excellent casein point. The best way to participate in a bull market in gold is to buy goldshares (or a gold mutual fund). Not only is it simpler to buy gold shares thanbullion, gold shares tend to rise faster than the price of gold. When the priceof bullion is rising, unhedged gold stocks also rise faster than gold-mining
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companies that hedge their gold production. [The AMEX Gold Bugs Index(HUI) includes only unhedged gold stocks.] Energy stocks (or energy sectorfunds) are an excellent way to participate in rising oil or natural gas prices.Basic material stocks (like aluminum and copper) benefit when thesesame commodities are rising. Forest product stocks benefit from rising lumber prices, which were also showing signs of bottoming by the summer of2003. Rising agricultural prices increase the demand for farm equipment likelarge tractors. Some food stocks may also benefit from rising livestock andpoultry prices. Investors can benefit from rising prices in commodities bybuying individual common stocks related to these markets. The availabilityof sector mutual funds and Exchange Traded Funds (ETFs) also makes itmuch easier for investors to take advantage of strong commodity markets byputting funds in stock sectors that are tied to these markets.
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C H A P T E R 11
Futures Marketsand Asset Allocation
RELATIVE STRENGTH ANALYSIS AMONG ASSET CLASSESThe previous chapter used relative strength analysis to compare the commodity and stock markets. The CRB Index was starting to outperform stockprices for the first time in 20 years in what was described as a generationalshift from paper to hard assets. This chapter expands on the use of ratio analysis to show how to measure the relative strength between bonds, stocks,and commodities in order to determine which of the three asset classesis doing the best at any given time. The idea is to concentrate one’s capitalin the classes that are doing the best and to avoid the ones that are doingthe worst. Fortunately, ratio charts make it relatively easy to compare thestrength or weakness of the three market groups. Ratio charts can help warnof impending trend changes and can be an important supplement to traditional chart analysis. One need not be a charting expert to learn how to spotsuch trend changes. Market developments since 2000 provide several strikingexamples of why it is important to know which markets are going up—andwhich ones are going down.
BONDS VERSUS STOCKSBonds and stocks are always competing for investor money. When investorsare optimistic about the stock market and the economy, they usually putmore money into