market, the next sector that should start to exert market leadership in the earlystages of a new economic expansion is Technology.
TECHNOLOGY LEADERSHIP IS A GOOD SIGNFigure 13.5 shows the percentage gains of the major stock market averagesfrom October 2002 (when the stock market hit bottom) until June 16, 2003.The top percentage gainer during these eight months was the Nasdaq Composite Index which gained 37 percent. The small-cap Russell 2000 Index
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1 October 2002 - 16 Jun 2003
35.0%30.0%25.0%20.0%15.0%10.0%5.0%
19.20%
17.39%
12.15%
16.68%
17.25%
37.31%
24.28%
0.0%
S&P 500
DJIA
DowTransports
DowUtilities
NYSE
Nasdaq
Russell2000
-5.0%-10.0%-15.0%-20.0%
© StockCharts.com 2003
FIGURE 13.5
From October 2002 to June 2003, the Nasdaq and the Russell 2000were top gainers.
gained 24 percent to take second place (more on that later). The S&P 500 andthe Dow Industrials are the laggards, showing gains of only 19 percentand 17 percent, respectively. On relative strength grounds, the technologydominated Nasdaq market was the clear leader. Historically, it is usually agood sign for the rest of the market when the Nasdaq is leading it higher.
NASDAQ LEADS MARKET HIGHER DURING 2003Figure 13.6 is a ratio of the Nasdaq divided by the S&P 500. The ratio peakedduring 2000 as the bubble in Nasdaq market burst. The ratio line shows agradual leveling-off starting in October 2002 (which is where we obtained thepreviously-cited performance numbers). The rising ratio line since thatbottom shows that the Nasdaq market was stronger than the S&P 500 overthose eight months.The Nasdaq is dominated by large technology stocks. One way to determine if the Nasdaq Composite rise is being led by technology stocks is to
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Nasdaq / S&P 500 Ratio
2.102.052.001.951.901.851.801.751.701.651.601.551.501.45© StockCharts.com 2003
F M A M J J A SO N D
FIGURE 13.6
FM A M J J A S O N D
FM A M J J
The Nasdaq has been outperforming the S&P 500 since October 2002.
compare its performance to the Nasdaq 100 Index, which includes the largestnonfinancial stocks in the Nasdaq market (which are mainly in technology).During the eight months in question (from the October 2002 bottom to June2003), the Nasdaq 100 gained 42 percent, which is 5 percent better thanthe Nasdaq Composite advance of 37 percent. The stronger performance bythe Nasdaq 100 shows that the Technology sector was primarily responsiblefor the Nasdaq’s ability to outperform the rest of the market from the fourthquarter of 2002 through the middle of 2003. Technology performance iswhat should happen as the economy moves into the Early Expansion phaseof the cycle.
TRANSPORTATION LEADERSHIPMoving up the left side of Stovall’s circle further into the Early Expansionphase of the economic cycle, one finds Transportation. If the economy isgoing to produce goods, it has to also transport them. (The Dow Theory,
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which is the oldest technical theory of market behavior, states that for a truebull market (and an economic recovery) to occur, the Dow Industrials andthe Dow Transports must move up together. While the Industrial companiesmanufacture the goods, the Transportation companies move them. One cannot exist without the other.) There is another element at work here in theeconomic cycle and it has to do with oil. As previously mentioned, rising oilprices during 1999 were especially damaging to Transportation stocks; theyfell heavily that year. Rising oil prices (and a rising Energy Sector) in 1999also contributed to the end of the economic expansion in 2000. After the economic slowdown, oil prices peaked and Energy stocks weakened. This usually gives a boost to Transportation stocks and is another sign that things aregetting better.Figure 13.7 shows the Dow Jones Transportation Average during thesecond quarter of 2003 exceeding the highs hit during the fourth quarter of2002. This upside move coincided with a similar breakout in the Dow JonesIndustrial Average, meaning that both key stock averages were moving uptogether by June 2003. This is what should happen if the stock market isbottoming and an economic recovery is starting. More importantly, the ratio
2600.0
Dow Jones Transportation AverageMoving Average (200)
2500.02400.02300.02200.02100.02000.00.290
Dow Transports / DJIA RatioEMA(20)
0.2800.270© StockCharts.com 2003
Aug
Sep
FIGURE 13.7
Oct
Nov
Dec
Feb
Mar
Apr
May
Jun
0.260
Jul
The Dow Transports have been stronger than the Dow Industrials during 2003.
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line beneath the price chart shows the Transports moving up from theMarch 2003 low faster than the Industrials. If this relative strength continues, it would have two positive implications. The first is that the risingTransports, which are also considered to be cyclical in nature, are startingto show leadership just when they should in the early stages of a new economic expansion. The second is that stronger Transports are usually associated with weaker oil prices. Since rising oil prices contributed to theeconomic slowdown in 2000, weaker oil prices in 2003 should help to stimulate an economic rebound.
CYCLICALS STARTING TO OUTPERFORM STAPLESChapter 4 explained how economically sensitive cyclical stocks and the moredefensive consumer staples compete for investor funds. In addition, it illustrated how the relationship between these two market sectors tells us something about consumer sentiment and the strength or weakness of the economy.When investors are more optimistic about the economy, they favor cyclicalstocks. The very word cyclical implies that they are tied to the businesscycle. As a result, cyclical stocks usually do better when the economy is onthe upswing and worse when it is in decline. The opposite is the case withconsumer staples. They lag behind when the economy is gaining momentum,but become safe havens when things start to look bad. This was the case inthe spring of 2000 when “scared” money moved aggressively into these moredefensive stocks. Figure 13.8 plots a ratio of the Morgan Stanley CyclicalIndex divided by the S&P Consumer Staples Index. The direction of the ratioline tells us something about the direction of the economy—or at least whatthe markets expect for the economy.The ratio peaked during the first half of 2000 as the stock marketpeaked. Money flowed out of economically sensitive cyclical stocks andinto economically resistant consumer staples. It was a sign that investorswere already starting to anticipate an economic slowdown. The situation inthe middle of 2003 is exactly the opposite. The cyclical/staple ratio hasbeen rising since October 2002. More importantly, it has broken the downtrendline extending back to the early 2000 peak and has established a pattern of higher highs and higher lows. This new uptrend in the ratio lineimplies that cyclical stocks have gained dominance over consumer staplesfor the first time in three years. This type of sector rotation is another signthat the market has become more optimistic about the direction of the business cycle.
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Cyclicals / SP 500 Cons Staples Ratio
© StockCharts.com 2003
3.13.02.92.82.72.62.52.42.32.22.12.0
Apr Jul Oct
FIGURE 13.8
Apr Jul Oct
Apr Jul Oct
Apr Jul Oct
Apr Jul
The break of the trendline in April 2003 signalled new leadership in cyclicals.
SMALLER STOCKS LEAD AT BOTTOMSThe performance numbers given earlier (from the October 2002 bottom toJune 2003) showed the small-cap Russell 2000 Index outperforming both theDow and the S&P 500 (Russell +24 percent, the S&P 500 +19 percent, the Dow+17 percent). This outperformance by smaller stocks also held up through thefirst six months of 2003. If the relatively strong performance by small-cap overlarge-cap stocks continues, it would bode well for both the stock market andthe economy. Smaller stocks usually lead the stock market when the economy is coming out of recession. The historical track record is impressive. Sixrecessions took place between 1960 and 1991. Small stocks outperformedlarge stocks in the first year following each of these previous recessions.Figure 13.9 plots a relative strength ratio of the small-cap Russell 2000Index divided by the large-cap Russell 1000 Index. The ratio bottomed duringOctober 2002 when the entire stock market bottomed. Since then, small capshave risen more than large caps, as evidenced by the rising ratio line. Thebreaking of the down trendline in April 2003 was another compelling chartsign of a new investor preference for smaller stocks.
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Russell 2000 / Russell 1000 Ratio
0.9000.8900.8800.8700.8600.8500.8400.8300.8200.8100.8000.7900.780© StockCharts.com 2003
F
M
A
FIGURE 13.9
M
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A
S
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N
D
F
M
A
M
J
J
The break of the trendline in April 2003 signalled new leadership in small caps.
SECTOR ROTATION MODELFigure 13.10 gives another visual representation of how sectors rotatethroughout the business cycle. This theoretical model is also based on SamStovall’s research. It presents the same data as Figure 13.1, but is shown ingraph form. Notice that the Market Cycle precedes the Economic Cycle atpeaks and troughs, further proof that the stock market turns before the economy and is a leading indicator for the economy. The Sector Rotation Modelshows that Energy and Consumer Staples are strongest as the EconomicCycle weakens. The transition from Recession to Early Recovery sees marketleadership coming from Cyclical and Technology stocks.
SECTOR ROTATION MODEL SUPPORTING DATAMore information goes along with the Sector Rotation Model shown in Figure13.10. It has to do with economic/fundamental factors that accompany dif-
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TechnologyBasic IndustryStaplesUtilitiesCyclicalsIndustrialEnergyServicesFinance
Full Recession
Early Recovery
Full Recovery Early Recession
Market Bottom Bull Market
Market Top
Bear Market
Legend:
Market Cycle
Economic Cycle
FIGURE 13.10
A visual look at Sector Rotation throughout the business cycle.
ferent stages in the business cycle. These are less technical in nature but doserve to round out the type of chart analysis generally employed in intermarket work. The factors are: consumer expectations, industrial production, thedirection of interest rates, and the slope of the yield curve. By keeping an eyeon these factors, a chartist is able to better discern if they are meshing withrelative strength performance charts. So far, the relative performance of thevarious market sectors has been used to determine the position of the business cycle. Let’s see what these four factors should be doing as the economygoes through expansion to contraction and then back to expansion.Cycle Stage:
Recession
EarlyRecovery
Recovery
EarlyRecession
Consumer Expectations:Industrial Production:Interest Rates:Yield Curve:
RevivingBottomingFallingNormal
RisingRisingBottomingSteep
DecliningFlatRisingFlattening
Falling SharplyFallingPeakingInverted
Consumer Expectations are very important because consumer spendingaccounts for two-thirds of the economy. Rising Consumer Expectation in theEarly Recovery phase of the economic cycle usually translates into higherconsumer spending. When Consumer Expectations are falling sharply in
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early recession, consumer spending dries up, which contributes to the economic slowdown. Industrial Production (IP) is one of the most widely followed measures of economic activity. During a recession, with business andconsumer spending on the decline, Industrial Production is falling. When IPstarts to rise, it is an early sign that the economy is recovering.
INTEREST RATE TRENDSThe subject of how interest rates behave during periods of economic expansion and contraction has already been covered. It related to the discussionsof how the bond market fits into the economic cycle. As a rule, interest ratesrise during an economic recovery and fall during an economic contraction.As this model suggests, a rapid rise in interest rates usually occurs in the latestages of economic recovery (usually caused by Fed tightening), which contributes to the eventual recession. Conversely, rapidly falling interest ratesduring a recession (usually caused by Fed easing) contribute to the eventualeconomic recovery. Interest rates have a tendency to bottom during the earlyrecovery phase. Thus the direction of interest rates is one way to measure thestrength or weakness of the economy. The yield curve provides investorswith another way.
THE YIELD CURVEThe yield curve measures the slope (or spread) between short-term ratesand long-term rates. When the yield curve is normal, long-term rates arehigher than short-term rates. The slope of the yield curve is caused mainly bymovement in short-term rates. Short-term rates are the ones most directlyimpacted by Federal Reserve policy. The Fed controls the direction of shortterm rates; inflationary (or deflationary) expectations control the direction oflong-term rates. During an economic recovery, the yield curve has a tendencyto flatten out. This means that short-term rates are rising faster than longterm rates and the spread between the two flattens. The crucial point comeswhen short-term rates exceed long-term rates. It is a dangerous situationcalled an inverted yield curve and is usually an early signal of an economiccontraction. Chapter 7 showed how an inverted yield curve in January 2000(resulting from rising oil prices and Fed tightening during 1999) was an early
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sign that the upward expansions in the stock market and the economy werenearing completion.During a recession, the yield curve normalizes. This happens becausethe Fed lowers short-term rates (as they started doing at the beginning of2001). Long-term rates fall as well, but they do so more slowly. A steep yieldcurve is usually a prerequisite for early recovery. A flattening yield curve isa sign of an economy that is in recovery. The flattening yield curve can occurin two ways. One way it can happen is if short-term rates start rising fasterthan long-term rates as the economy strengthens. Another way is if long-termrates start dropping faster than short-term rates.
YIELD CURVE FLATTENS DURING 2003Figure 13.11 is a snapshot of the yield curve as of June 17, 2003. The blackline shows that the yield curve has an upward slope, which means that it ispositive (or normal). (The line starts with lower short-term rates to the leftand moves upwards toward higher long-term rates to the right.) There is a“shadow” on the black line, which shows where it has been over the previousfew weeks. The fact that the current yield curve (which is the black line) isat the lower end of the shadow means that it is moving lower (or flattening).This means that the spread between short and long-term rates is narrowing.The flattening yield curve during the spring of 2003 was primarily due to thefact that long-term rates started falling faster than short-term rates. The rate
1,600.00 S&P 500 ($SPX)
7.18%
17 June 2003Close: 1,011.601,233.335.05%
866.672.92%
17 June 2003 (50)
0.79%Short
5Y
FIGURE 13.11
10Y
© StockCharts.com 2003
500.0030Y
95 1996
1997
1998
A snapshot of the yield curve on June 17, 2003.
1999
2000
2001
2002
03
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on the three- and six-month T-bills had fallen below 1 percent. The 10-yearTreasury note and the 30-year Treasury bond were yielding 3.3 percent and4.4 percent, respectively.During May 2003, the Fed announced that it would lower rates evenmore (and keep them low) in order to head off any threat from deflation.Since short-term rates could not drop much more, most of the downwardmovement was seen in the long end of the yield curve. The buying of Tbonds and notes was also influenced by the Fed’s hinting that it might bewilling to buy 10-year Treasury notes to keep long-term rates from rising.And with short-term rates nearing zero, money managers (and investors)were forced to move further out along the curve to find higher yields. As lowas interest rates were, a 4 percent yield on the T-bond still seemed betterthan 1 percent on a T-bill.The search for yield in the low interest rate environment that existedduring the first half of 2003 also caused investors to move into investmentgrade corporate bonds and high-yield (junk) bonds, which offered higherreturns than Treasuries. The same motivation also caused fixed-incomefunds to flow into emerging-market bonds. These more aggressive movesindicated that investors were willing to assume more risk, signalling growingconfidence in the economy.
ANOTHER VIEW OF THE YIELD CURVEFigure 13.12 plots the ratio between the yield on the 3-month Treasury billand the 10-year Treasury note. Plotted this way, the relationship betweenthe two can be seen more easily. In 2000, the short-term rate moved over thelong-term rate, (as a result of Fed tightening), causing the inverted yieldcurve that led to a weakening of the economy. Short-term rates started to fallat the start of 2001 when the Fed began an aggressive easing policy. The dramatic drop in short-term rates relative to long-term rates continued throughout 2001 (as the Fed lowered short-term rates 11 times). Short-term ratesleveled off in 2002. The ratio fell to a new low during the summer of 2003 dueto a jump in long-term rates.On June 25, 2003, the Federal Reserve lowered the Fed funds rate a quarter point to 1.00 percent. This was the lowest level in 45 years. The immediate market reaction was not what the Fed had in mind. Within six weeks ofthe quarter-point rate cut, the yield on the 10-year Treasury note jumped from
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3-Mo T-Bill / 10-Yr T-Note Ratio
1.11.00.90.80.70.60.50.40.3
© StockCharts.com 2003
Apr Jul Oct
FIGURE 13.12
Apr Jul Oct
Apr Jul Oct
Apr Jul Oct
Apr
The falling ratio shows a steepening yield curve from the start of 2001. Thatwas the result of the Fed's lowering short-term rates thirteen times throughthe middle of 2003.
3.25 percent to 4.50 percent. Bond traders were hoping for a more aggressivehalf-point cut to emphasize the Fed’s commitment to battle deflation. Manytook the less aggressive move as a sign that the Fed’s 13th easing since January 2001 might be its last. This caused heavy selling in the bond market. Thejump in long-term rates also reflected the market’s view that the Fed hadabandoned its earlier plan to buy 10-year Treasury notes.
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C H A P T E R 14
Diversifyingwith Real Estate
LOCATION IS EVERYTHINGThey say that the three key words in real estate are “location, location, location.” Since the big bear market in stocks began in 2000, real estate has beena good place for investors to locate their money. This has been true both interms of home ownership and any stock related to homebuilding and realestate. This is not necessarily the norm, however. Real estate has usually beenviewed as an inflation hedge. Real estate prices were usually tied to the cycleof inflation. The value of homes and real estate rose during periods of highinflation and fell during periods of low inflation. The price of a home peakedalong with the inflationary bubble around 1980. Home prices then followedthe inflation rate, dipping into the 1990s. More recently, however, their pathshave diverged. Over the last five years, home prices have jumped 39 percent.Home values jumped 7.5 percent each year in 2001 and 2002 as the inflationrate dropped to 2 percent. Part of the reason for the aberrant behavior of realestate during this down cycle in the economy is the fact that interest rateshave acted differently and have fallen to the lowest levels since the 1950s.
THIS CYCLE HAS BEEN DIFFERENTThere is no question that the latest downturn in the business cycle has beendifferent from anything seen since in the post–World War II era. Deflationarytendencies that started five years ago have changed many of the traditionalintermarket relationships. One of the key relationships that has changed is217
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the link between bonds and stocks. In previous postwar recessions, bond andstock prices fell together. Bond prices turned up before stocks, but not untilthe economy was well into its down cycle. This meant that long-term rateswere still rising even as the economy was weakening. The bear market instocks that started in 2000, however, saw a major decoupling of bonds andstocks. Bond prices turned up in the spring of 2000 as the stock marketpeaked. Bond prices continued rising during the next three years as stockprices fell. This unusual behavior is consistent with a deflationary environment. The plunge in long-term rates that started in the spring of 2000 (just asthe stock market peaked) gave a double boost to real estate stocks andhomebuilders. Both benefit from falling interest rates. REITs also benefitfrom a falling stock market, especially technology stocks.
REITS TURN UP AS NASDAQ PEAKSChapter 7 talks about the rotation into Real Estate Investment Trusts (REITs)that started in the spring of 2000 as the bubble in the Nasdaq market wasbursting. (REITs own everything from apartments to offices to shoppingmalls.) One of the reasons for the 2000 rotation is that REITs have a low correlation to the rest of the stock market. This makes REITs an excellent diversification vehicle, especially when the market is in trouble. Maybe even moreimportantly, REITs have a tendency to show a negative correlation to technology stocks. This means they usually trend in the opposite direction of theNasdaq market, which is dominated by technology shares. What better placeto move some money into when the Nasdaq is peaking? (REITs also pay ahigh dividend rate, which makes them an excellent defensive sector, especially when interest rates are falling along with stocks.)
ROLE REVERSALS IN 2000Figure 14.1 plots the Nasdaq market with the Morgan Stanley REIT Indexfrom the start of 2000 to the start of 2003. Their inverse correlation is dramatic when looked at in this fashion. Going into the spring of 2000, the Nasdaq market was soaring while REITs were in decline. During that spring, thepeak in the Nasdaq coincided almost exactly with a major upturn in the REITIndex. For the next two years REITs rose while the Nasdaq kept tumbling.The plunging stock market was not the only thing helping REITs. Interestrates also played a big role in the REIT revival. Figure 14.2 positions the REIT
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© StockCharts.com 2003
FIGURE 14.1
Both markets show an inverse relationship during 2000.
60.0%
REIT Index - Morgan Stanley10-Year T-Note Yield
50.0%40.0%30.0%20.0%10.0%0.0%-10.0%-20.0%© StockCharts.com 2003
Apr Jul Oct
FIGURE 14.2
-30.0%Apr Jul Oct
Apr Jul Oct
Apr Jul Oct
A clear inverse link is seen between REITs and rates.
Apr
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Index over the yield on the 10-year Treasury note. Here again, a clear inverserelationship can be seen. REITs bottomed early in 2000 just as rates werepeaking. REITs continued to rise as rates fell. Ironically, deflationary pressures were actually helping real estate stocks by pushing interest rates to thelowest levels in more than forty years. Homebuilders rose along with REITsfor the same reason.
THINGS START TO CHANGE DURING THE SUMMER OF 2002Figure 14.3 plots another comparison of the two competing markets—theNasdaq and REITs. It shows the REIT Index rising through a down trendlinein the spring of 2000 just as the Nasdaq was peaking. By the end of 2000, theNasdaq had fallen to the lowest level in two years while the REIT Index wassetting a new all-time high. To the far right of both charts, however, it can beseen that the relative fortunes of the two markets started to change. In July2002, REITs showed signs of peaking just as the Nasdaq market started tostabilize.
REIT Index - Morgan StanleyMoving Average (40 weeks)
REITs PEAKED IN JULYAS NASDAQ BOTTOMED
450.0400.0
REITs DOWNTREND
350.0REITs BOTTOMED IN SPRING2000 AFTER NASDAQ PEAKED
300.0
© StockCharts.com 2003
Nasdaq CompositeMoving Average (40 weeks)
NASDAQ PEAKS IN SPRING 2000
5000.04000.03000.0
NASDAQ RISES
2000.0
NASDAQ STABILIZED IN JULY
A
J
O
FIGURE 14.3
A
J
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A
J
O
A
J O
A
REITs bottomed as the Nasdaq peaked in 2000.
J
O
A
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REITS PEAK IN 2002 AS MARKET BOTTOMSFigure 14.4 plots three lines: the Dow Jones REIT Index (top line), the yieldon the 10-year T-note (middle line), and the Nasdaq Composite Index (bottom line). In order to understand the movement in the REIT market fromthe summer of 2002 to the summer of 2003, it is necessary to compare allthree lines. The peak in the REIT Index occurred right at the start of July2002. Later that same month, the Nasdaq (and the rest of the market)started a bottoming process that lasted until the following spring whenstock prices started to rise. A reverse rotation started in July 2002. Moneystarted moving out of REITs and back into other stocks, especially intotechnology.Although the 2002 peak in REITs coincided closely with a bottom in theNasda