time it was out of commodities and back into the dollar, bonds, and stocks.
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1990 and the First Persian Gulf War
© StockCharts.com 2003
Oil - Light Crude - Continuous Contract
PERSIAN GULFWAR STARTS
40.035.030.0
IRAQ INVADESKUWAIT
25.020.0
Gold - Continuous ContractOUTBREAK OF WAR
420.0400.0380.0360.0
SIX MONTHS LEADINGTO PERSIAN GULF WAR
Feb Mar Apr May Jun
FIGURE 2.10
Jul Aug Sep Oct
Nov Dec
Feb Mar Apr May
Gold and oil tumbled at the outbreak of war in mid-January 1991.
Bonds rallied at the start of the war, but not as dramatically as stocks.Part of the reason for the more muted reaction in bonds was that U.S Treasuries had already risen 15 percent since October in an apparent “flight tosafety.” When the war started, stocks did better than bonds for the firstmonth thereafter as traders moved money from the safety of bonds back intothe stock market. Figure 2.11 shows the dollar bottoming within a monthafter the outbreak of war. This contributed to the tumble in commodityprices but was good for bonds and stocks. Figure 2.11 also shows that bondprices had bottomed during October (as oil peaked) and had acted as a safehaven for the next three months leading up to the war. Bonds hit a temporarypeak after the war when they lost some of their safe haven status and moneyrotated back into stocks.The Dow also hit its lowpoint in October, but had shown only modestgains until the following January. From mid-January to mid-February (themonth following the start of the war), the Dow had risen nearly 500 points(a 20 percent gain) while Treasury bonds gained a much smaller 5 percent. Itis interesting to once again see bond prices acting as a leading indicator forstocks. Bonds peaked before stocks during the first half of 1990, and ralliedmore than stocks during the second half. (One of our intermarket principles
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INTERMARKET ANALYSIS
US Dollar Index
95.092.590.0
DOLLAR BOTTOMEDAFTER WAR STARTED
87.585.082.5
30-Year US Treasury Bond Price
77.575.072.5
LEADING UP TO WAR,FLIGHT TO SAFETYBOOSTED BONDS
70.067.5
© StockCharts.com 2003
Feb Mar Apr May Jun
FIGURE 2.11
Jul Aug Sep Oct
Nov Dec
Feb Mar Apr May
The dollar bottomed a month after the outbreak of the Persian Gulf War.Bonds bottomed the prior October.
Dow Jones Industrial Average
3000.02950.02900.0INVASION OFKUWAIT
2850.02800.02750.02700.02650.02600.02550.0START OFPERSIANGULF WAR
2500.02450.02400.0
© StockCharts.com 2003
F
M
FIGURE 2.12
A
M
J
J
A
S
O
N
D
F
M
A
M
The Dow soared in the months after the Persian Gulf War started.
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1990 and the First Persian Gulf War
29
is that bonds usually lead stocks.) Figure 2.12 shows the Dow Industrialssoaring in the months after the war started. The Dow had fallen from 3,000 to2,400 in the three months after the Iraq invasion before bottoming in Octoberalong with bonds (as oil peaked). The January pullback retraced about half ofthe rally from October to December and has been described by chartists as aright shoulder in a bullish head and shoulders bottom (the right shoulder isthe third and final trough in a head and shoulders bottom).
1990 DIVERGENCE BETWEEN OIL AND OIL SHARESThe action of oil stocks throughout 1990 provides us with another intermarket lesson. During that year, oil stocks acted as a leading indicator for crudeoil, both on the way up and on the way down. Although oil stocks soaredwith oil prices over the summer, they had actually turned up two monthsearlier. More importantly, oil stocks peaked a couple of months before thecommodity did that October. As the price of crude was nearing $40 thatautumn, oil shares had already started dropping. This gave an early warningof an oil top.While putting the finishing touches on my earlier manuscript in theautumn of 1990, I included the following words: “As the third quarter of 1990ended . . . falling oil shares have set up a negative divergence with the priceof oil, which is testing its all-time high at $40.” Figure 2.13 is the same chartthat I included in the earlier book. You can see the obvious negative divergence to which I referred. I wrote these words because one of the intermarket relationships has to do with how a commodity relates to its shares. Theyshould move in the same direction. For example, rising oil shares shouldaccompany rising oil prices. When they start to diverge, it is usually an earlywarning of an impending trend change. In addition, stocks usually changedirection ahead of their related commodity. This makes energy shares aleading indicator for oil. Anyone who was aware of this relationship in 1990got an early warning that the oil rally was nearly done, which also meant thatthe bear markets in bonds and stocks were nearing completion as well. Bothmarkets hit their lows in October, just as oil was peaking near $40.
THE IMPORTANCE OF $40 OILThe $40 price level plays an important role in the history of crude oil. Thisresistance level has stopped every major advance in the price of crude in
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FIGURE 2.13
Crude oil versus oil stocks during 1990. Oil stocks had spentthe first half of 1990 in a holding pattern while oil pricesweakened. Oil stocks exploded to new highs in early Julywhen oil bottomed. As the third quarter of 1990 ended,however, falling oil shares have set up a “negative divergence”with the price of oil, which is testing its all-time high at $40.
over 30 years. Oil peaked at $40 in 1980 just as the commodity bubble wasbursting. It reached that level again during Desert Storm in 1991, then turnedback down again. Twelve years later, during the second Iraq crisis (in theearly part of 2003), oil prices reached that key level once again before fallingsharply at the start of that war.
INTERMARKET LESSONS LEARNED DURING 1990Some of the intermarket relationships that manifested themselves during1990 were:• Bond prices and commodity prices moved in opposite directions• A falling dollar boosted commodities and hurt both bonds and stocks
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• Bonds peaked ahead of stocks and then led them higher after October• Gold and oil prices moved in the opposite direction of stocks all year• All major global markets trended together, including bonds and stocks• Oil shares provided an early warning of the October top in crude oil prices• Rising oil prices contributed to another recession
COMPARISONS BETWEEN 2003 AND 1991Intermarket trends witnessed during the Desert Storm era were remarkablysimilar to those witnessed during the second Iraq crisis over a decade later in2002–2003. In the later conflict, gold and oil prices soared (while the dollarand stocks fell) in the months leading up to the second Iraq invasion just asthey had in 1990. In 2003, traders were expecting a replay of the events of1990–1991 at the outbreak of war—and they were not disappointed. The weekthat hostilities started (March 20, 2003) the U.S. stock market recorded again of 8 percent—the biggest in 20 years. Oil prices (which had peaked at$39.99 on February 28) fell $13 for a loss of 33 percent. Gold prices (whichpeaked at $390 on February 5) had fallen $60, or 15 percent. The U.S. dollarjumped 4 percent as gold fell and stocks rose. Bond prices, which had beenrising as stocks fell, had their biggest drop in two years; there was a massiveswitch from the relative safety of bonds back into stocks.International reactions were equally dramatic. Global bond yields jumpedas geopolitical tensions eased. In currency markets the Euro, the Japaneseyen, and the Swiss franc (which had previously acted as a safe haven) fellsharply. Stock markets all over the world jumped markedly. The GermanDAX (which had been the weakest market in Europe) gained 10 percent,Korea’s index rose 7 percent, and Brazil’s 3 percent, to name just a few examples. Within a week of the start of the 2003 Iraq war, all the preexisting intermarket trends had been reversed—just as had happened in 1991. In addition,each market did exactly what it was expected to do. The two situations werenot completely the same, however.While the intermarket reactions during the two wars in the Mideast wereremarkably similar, long-term trends were not. In 1990, the stock marketwas in the midst of a major bull market that had another eight years to run.Commodity markets were in the middle of a major bear market that lastedanother decade. The rise in commodities—and the decline in stocks—in 1990were short-term corrections to long-term trends. After January 1991, stocksresumed their bull market while commodities resumed their downtrend. Atthe start of 2003, however, the situations were reversed. The 20-year secularbull market in stocks had ended, and commodities had entered a new bull
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market. This situation was very different from 1990. The intermarket reactions were similar in both Iraq wars; what differed, though, were the majortrends of the key markets.
JAPAN NEVER RECOVERSAll the major global stock markets resumed their long-term bull trends at thestart of 1991—with one notable exception. The Japanese stock market,which had peaked near the end of 1989, kept dropping even after resolutionof the first Persian Gulf War. By the start of the second Iraq war in 2003, theNikkei 225 (the main index of Japanese stocks) had just fallen to the lowestlevel in 20 years. During this 13-year decline, the Nikkei dropped from 39,000to 8,000, losing close to a staggering 80 percent of its value. This was thebiggest crash in a major stock market since 1929. Although the Japanese collapse did not have an immediate influence on other global markets, its bearish influence was felt a decade later when Japanese deflation was exportedto other parts of the world. The 78 percent decline in the Nasdaq marketafter 2000 also provoked comparisons to the deflationary years in the UnitedStates from 1929–1932. As is described later in the book, deflation became abig issue at the start of the new millennium and changed some importantintermarket relationships. Although nobody knew it at the time, the deflationary problems of the early 2000s actually started with the bursting of theJapanese bubble just as the 1980s were ending and the 1990s were starting.
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CHAPTER 3
The StealthBear Marketof 1994
THINGS LOOK GOOD FROM 1990 THROUGH 1993Immediately after the Persian Gulf War, intermarket trends turned favorableagain for the next three years. From early 1991 to the end of 1993, bond andstock prices rose together. Commodities were generally weak. The U.S. dollar,which bottomed early in 1991, was firm. A dip in the dollar from mid-1991 tomid-1992 did not cause much damage to bonds and stocks, mainly becausecommodities remained weak. (Recall that a falling dollar only hurts bonds andstocks when commodities are rising.) Things started going badly for stocks,however, during the first quarter of 1994, then got steadily worse as the yearprogressed. Bond prices fell along with stocks as commodity prices rose. Therise in commodities was aided by a falling U.S. dollar, which peaked at the startof 1994 and fell during the rest of the year. Rising commodity prices and afalling dollar proved to be a bad intermarket recipe for bonds and stocks. Asis usually the case, however, early warning signs showed up in the bond andcommodity markets the previous year. Let’s take a look.
A DESCRIPTION OF THE CRB INDEXThe CRB Index is the most widely followed measure of commodity pricedirection. During 1993 and 1994, it was made up of 21 commodity markets.Changes to the index in late 1995 reduced the number from 21 to 17. However, it still includes all of the major commodity groups: industrial metals,precious metals, energy, grain, livestock, and tropical commodities. Any33
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long-range chart that compares the CRB Index to Treasury bond prices willshow that they generally trend in opposite directions. However, the CRB Index is not the only commodity index. (It should be noted that the CRB Indexhas recently been renamed the CRB/Reuters Futures Price Index.)
THE CRB INDEX TURNS UP IN EARLY 1993Heading into 1993, commodity prices were falling as bond prices were rising.During the first quarter of 1993, however, the CRB Index turned higher androse through the balance of that year. Commodity and bond prices rosetogether until the fourth quarter of 1993, when bond prices suffered theirworst collapse in half a century. Since these two markets generally trend inopposite directions, the rise in the CRB Index provided an early warning thatthe uptrend in bonds was unsustainable. The interplay between bonds andcommodities during 1993 showed how activity in one asset class can affectanother—and how one market can act as a leading indicator for another.(Commodity prices usually turn up before bond prices turn down.) It is alsoan excellent demonstration of how intermarket relationships can sometimesseem “out of line” for a period of time but still carry a warning.In this case, the amount of time from the CRB bottom (in February) tothe bond peak (in September) was a relatively lengthy seven months, butthe end result was a virtual collapse in the bond market. Figure 3.1 shows theCRB Index and Treasury Bond prices rising together from February 1993until that autumn. The rise in commodity prices eventually contributed tothe collapse in bond prices during the fourth quarter of that year. Althoughthe CRB Index did a good job at warning investors of a serious downturn inbond prices, it gets bad marks in 1993 for precision timing because it turnedup half a year ahead of the peak in bonds. This brings us to the need to watchother commodity indexes and key individual commodities in order to get amore accurate read on the direction of commodity prices. And also toimprove the timeliness of their signals. This is done by a closer monitoring ofcommodity prices more directly tied to the economy.
WATCH INDUSTRIAL PRICESThe CRB Index is often influenced by agricultural markets. This was true inearly 1993; these markets accounted for most of the Index’s upturn. (Goldalso rose during that spring and summer.) Agricultural markets, however, are
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The Stealth Bear Market of 1994
FIGURE 3.1
35
Commodity Research Bureau Index of 17 commodity markets.The rise in commodity prices that started in early 1993 (point A)eventually caused the bond market peak at point B. Bond andcommodity prices usually trend in opposite directions.(MetaStock, Equis International, Inc.)
more often affected by weather than economic trends. For this reason, it is agood idea to consult other measures of general commodity price trends andcertain commodity sectors like industrial metals. Industrial metals like aluminum and copper are especially sensitive to economic trends because theyare used in the building of autos and homes and have other industrial appli-
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cations. For this reason, industrial commodities usually have a much closercorrelation to bond prices than other commodities that are more weatherrelated, like grain and produce markets.Copper prices actually fell during most of 1993 and only turned up thatOctober, just when bond prices were peaking. Figure 3.2 shows that the
FIGURE 3.2
The bond price peak in late 1993 coincided with a major bottomin copper. Falling copper prices imply economic weakness whichis bullish for bond prices. The dramatic rally in copper that beganin late 1993 helped push bond prices lower. (MetaStock, EquisInternational, Inc.)
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upturn in copper during the fourth quarter of 1993 coincided almost exactlywith the bond market peak. The chart also shows a strong inverse correlationbetween copper and bond prices. Copper fell throughout most of 1993 asbond prices rose. Copper turned up during the fourth quarter just as bondprices were peaking. Figure 3.2 shows that bond prices fell below a rising support line just as copper rose above a falling resistance line. (A support line isdrawn under price lows in an uptrend. A resistance line is drawn over pricepeaks in a downtrend. The breaking of those lines usually means that existingtrends are reversing.) Not only did the copper bottom coincide with the bondtop in late 1993, but the bulk of 1994 saw falling bond prices accompanied bysurging copper prices.Figure 3.3 is an overlay comparison of the copper and bond markets during 1993 and 1994. The chart shows them turning together during the fourthquarter of 1993. It also shows that copper prices rose through most of 1994while bond prices fell. During both years, bonds and copper maintained aclose inverse relationship. The rotation from a weak bond market to a strongcopper market accounted for an important sector rotation within the stockmarket. While interest rate sensitive stocks like utilities followed bondslower, industrial metal shares followed copper higher during 1994. Giventheir strong influence over interest rates and the fact that they are moreclosely tied to economic trends, industrial prices are preferred by most economists. It was only a matter of time until economists created a commodityindex of industrial prices.
THE JOURNAL OF COMMERCE (JOC–ECRI) INDEXThe most widely followed index of industrial commodity prices is the Journal of Commerce (JOC)–Economic Cycle Research Institute (ECRI) Industrial Price Index. The original JOC index was created in 1986 by Geoffrey H.Moore1 and his research staff located in New York. The latest JOC-ECRIIndex was revised at the start of 2000 by the same team of researchers. Whatdistinguishes this index from the others is the careful selection of commodities that have been shown to have the best cyclical relationship to inflation.What also distinguishes the JOC-ECRI Index from the others is the fact thatit includes only industrial prices—it excludes food, grains, and precious metals. The JOC-ECRI Index includes 18 industrial prices grouped into textiles,metals, petroleum products (including crude oil), and miscellaneous prod1Dr. Moore, now deceased, was one of this country’s leading experts on the businesscycle.
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FIGURE 3.3
Bond and copper prices usually trend in opposite directions.The 1993 bond peak coincided with a major bottom in copper.(MetaStock, Equis International, Inc.)
ucts (including plywood). The metals markets include aluminum, copper,lead, tin, zinc, and nickel.In 1993, the JOC Index tracked bond yields very closely. (Industrial commodities trend in the opposite direction of bond prices. Since bond pricesand yields trend in opposite directions, that means that industrial prices trend
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FIGURE 3.4
39
The upturn in the JOC Index of Industrial Material Prices coincidedexactly with the major bottom in bond yields in late 1993.
in the same direction as bond yields.) Figure 3.4 shows both markets fallingtogether throughout most of the 1993 and turning up together during thefourth quarter. They rose together for most of the following year. The JOCIndex gave traders a much more precise read on when interest rates weremore likely to trough—and when bond prices were about to begin their majordecline. (More information on the JOC-ECRI index can be found on thewebsite of the Economic Cycle Research Institute (www.businesscycle.com). We will refer to the pioneering work of Geoffrey Moore in Chapter 12when we discuss the rotation of bonds, stocks, and commodities at differentstages in the business cycle.)
GOLD AND OIL ARE ALSO IMPORTANTIn addition to industrial metals, two other commodities that should bewatched closely are gold and oil. Gold is viewed as a traditional leading indi-
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INTERMARKET ANALYSIS
cator of inflation and carries important psychological weight. Investors maynot be very concerned about rising soybean prices, but a jump in the price ofgold makes headlines. The Federal Reserve Board also watches gold pricesto determine if monetary policy is on course. Gold price direction also has amajor influence on the trend of gold mining shares.The price of energy has more than a psychological effect on the inflationpicture. It also has an important impact on the economy. The previous chapter discusses the fact that rising oil prices have been a contributing factor inmost recent recessions. Oil-related stocks are also largely dependent on thetrend of oil.A sharp rise in either of these two key commodities sends an immediatewarning to bond traders and an early warning to stock traders. A rise in bothcommodities is especially dangerous for bonds and stocks. During the summer of 1993, gold prices rose but oil prices continued to drop. As a result, thebond and stock markets were not impacted by the rise in gold. Oil pricesstarted jumping early in 1994. Rising gold and oil prices together added to thebearish sentiment in bonds and stocks that year.
GOLDMAN SACHS COMMODITY INDEXThe Goldman Sachs Commodity Index (GSCI) is the newest of the threeindexes. It includes most of the same commodity markets as the CRB Index,but is a trade-weighted index. In other words, it weights the various commodities according to their importance in world trade. As a result, energy pricescomprise over half of its weighting. It is thus not as useful in measuring overall commodity price trends, but is helpful in monitoring the impact of energyprices on the overall commodity price trend. The GSCI was the last of thecommodity indexes to turn up during the 1993–1994 time period. It bottomedjust as 1994 was starting and oil prices were starting to firm. This meant thatall three commodity indexes—the CRB, the JOC, and the GSCI—were risingat the start of 1994. Figure 3.5 shows the GSCI turning up sharply at the startof 1994. This was a sign that energy prices (which dominate the GSCI) wererising. An upside breakout in late 1995 also signaled higher energy inflation.Since none of these commodity indexes is perfect, it is a good idea tokeep an eye on all of them. The most convincing evidence of commodityprice trends occurs when all of the commodity indexes are trending in thesame direction, as they were at the start of 1994. The GSCI and the CRBIndexes are both traded as futures contracts and their prices are readily available and easily charted.
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FIGURE 3.5
41
A bullish breakout in late 1995 by this energy-dominatedindex signaled higher energy inflation. (MetaStock, EquisInternational, Inc.)
BONDS PEAK AHEAD OF STOCKSCommodity prices affect the direction of bond prices. Bond prices, in turn,affect the direction of stock prices. Rising bond prices (falling bond yields)are positive for equity prices. Falling bond prices (rising bond yields) arenegative for equities. Turns in the bond market, however, usually precede
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similar turns in the stock market by several months. As such, important turnsin the direction of bond prices can provide an early warning of an impendingturn in stocks. This was certainly the case in the months leading up to the1994 bear market in stocks. The bond market peaked during September1993. The stock market peaked during February 1994, five months after thebond peak. Figure 3.6 overlays the Dow Industrials and Treasury Bond prices
FIGURE 3.6
Bond prices usually lead stock prices. The bond market top inlate 1993 (point A) warned of a stock market top within sixmonths (point B). (MetaStock, Equis International, Inc.)
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during 1993 and 1994. The chart shows the stock market peaking within sixmonths of the bond market peak. It also shows the bond bottom during thefourth quarter of 1994 coinciding with a bottom in the Dow.
THE STEALTH BEAR MARKETBonds suffered their worst fall in decades. The major stock averages lost little more than 10 percent from peak to trough. The relatively small declines inthe major averages that year masked more serious damage in some sectors ofthe market, which is why it is often called a “stealth” bear market. Smallerstocks, as represented in the Russell 2000 and the Nasdaq market, lost 15 percent. Figure 3.7 compares the Dow Industrials with the New York StockExchange (NYSE) Advance–Decline line during 1994. The contrast betweenthe two lines is striking; it shows that the broader market suffered muchbigger losses than the major stock averages.The stocks that bore the brunt of that bear year were in the transportation and interest rate groups. The Dow Transports lost 26 percent, probablyowing to rising oil prices. The Dow Utilities were the hardest hit of all.Although they lost 26 percent from the start of 1994, they had actuallystarted falling along with bonds the previous September. The utilities’ totalloss was closer to 34 percent from peak to trough.
A LOSS FOR UTILITIES IS A GAIN FOR METALS IN 1994In addition to the negative macro effect that rising commodity and fallingbond prices have on the stock market, it is important to consider the dynamicrotation that is caused within certain stock sectors. This consideration leadsto an extremely important element in intermarket analysis: the interplaybetween the three asset classes (bonds, stocks, and commodities) whichhelps to explain the rotation within the stock market from sector to sector.This insight helps determine which sectors of the stock market to invest in atcertain times to ensure that an investor is always in the sector that is outperforming the general market—and out of the ones that are doing the worst.The events of 1993 and 1994 had dramatically different effects on two stockmarket sectors.Utility stocks are considered to be driven by interest rates and, as aresult, track bond prices very closely. Figure 3.8 shows the remarkably closecorrelation between Treasury Bond prices and the Dow Utilities in 1993 and
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FIGURE 3.7
(a) The Dow decline during 1994 was less than 10 percent.(b) The NYSE AD Line failed to support the Dow rally to newhighs in early 1994, creating a negative divergence. The broadermarket suffered much greater losses during 1994 in a “stealth”bear market. (MetaStock, Equis International, Inc.)
1994. Utilities peaked right along with bonds in September 1993 and continued to fall with bonds for the following year. During this time span, utilitieslost 34 percent of their value. In a climate of falling bond prices, utilities areoften among the stocks that suffer the greatest damage. (Financial stocksalso often suffer more when bonds are falling.)
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FIGURE 3.8
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Bond prices and utility stocks usually trend in the same direction.They peaked together in late 1993 and bottomed together in late1994. (MetaStock, Equis International,