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prelude to a peak in the economy. This is partly due to the simple fact thatsharply higher oil prices are bad for the economy, and oil shares rise withenergy prices. In addition, the Fed usually responds to higher oil prices byraising interest rates, which usually leads to economic slowing. Both eventstook place in 1999 and the early part of 2000.
WHY IT IS BAD WHEN ENERGY AND CONSUMER STAPLESARE STRONGOne way we can tell when rising energy prices are starting to slow the economy is when market leadership starts to shift from Energy to ConsumerStaples. Since that shift takes place gradually, the real danger sign becomesevident when Energy and Consumer Staples are the strongest two sectors inthe stock market. This was the case during the first half of 2000.Figure 7.11 shows the performance of four market sectors—Energy,Staples, Cyclicals, and Basic Industry—at the halfway mark of 2000 (all foursectors are plotted around the S&P 500, which is the flat line in the middleof the chart). It can be seen that Energy and Staples are the two strongest
S&P 500 Large Cap IndexEnergy Select Sector SPDRConsumer Staples Select Sector SPDRMaterials Select Sector SPDRConsumer Discretionary Select Sector SPDR
25.0%Energy
20.0%15.0%Staples
10.0%5.0%0.0%-5.0%-10.0%
Cyclicals-15.0%Basic Industry-20.0%© StockCharts.com 2003
Feb
FIGURE 7.11
Mar
Apr
May
Jun
Energy and Consumer Staples were top sectors during the first half of 2000.
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groups. This is consistent with market leadership in the early stages of an economic slowdown. At the same time, the two economically sensitive groups—Basic Materials and Cyclicals—are the weakest. This also makes sense in aweakening economy. As the economy starts to slow more, the rotation worksits way down the right side of Stovall’s diagram to Utilities and Financials.Let’s see what the diagram was showing during the fourth quarter of 2000.
NOVEMBER 10, 2000: IT’S THE ECONOMYFigure 7.12 shows another type of sector performance chart that waspublished on November 10, 2000 on the MurphyMorris.com website in anattempt to see whether the market sectors were following their normal economic rotation in a slowing economy. Sure enough, they were. Figure 7.12uses a bar chart format to compare the performance of the 10 S&P marketsectors. It shows how closely the sectors followed Stovall’s economic cyclediagram. The four top performers during the first 10 months of 2000 wereEnergy (17 percent), Consumer Staples (18 percent), Utilities (21 percent),and Financials (20 percent). The three weakest sectors were the economically sensitive Basic Industries (–25 percent), Cyclicals (–22 percent) and
31 December 1999 - 9 November 200025.0%UtilitiesEnergy
Financials
Staples
20.0%15.0%10.0%
Industrials
5.0%
+5.96 %-4.70 %
-22.64 %
-23.88 %
+17.99 %-25.90 %
+18.18 %
+21.08 %
+20.68 %
0.0%
-7.51 %
-5.0%S&P 500Services
-10.0%-15.0%-20.0%
Cyclicals
-25.0%Technology
Basic Industry
-30.0%© StockCharts.com 2003
FIGURE 7.12
Energy, Staples, Utilities and Financials were top sectors in the first tenmonths of 2000.
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Technology (–23 percent). All of these trends were consistent with a slowingeconomy.
TWOFOLD USE OF SECTOR ROTATION DIAGRAMThe use of the sector rotation diagram is twofold. By knowing which sectorsare in leadership, it is possible to make a judgment about the state of the economic cycle. The message in 2000 was one of economic slowing. The secondand more valuable use is in the implementation of sector rotation strategies.In 1999, for example, Energy stocks were the preferred sector in which tobe. In 2000, however, the diagram would have suggested gradual rotationinto Consumer Staples, Utilities, and Financials. All three rose in 2000. Froman asset allocation standpoint, economic slowing favors bonds over stocks.Economic slowing is also bad for commodities. During that fateful year,stocks and commodities peaked while bonds started an impressive bull run.It was all there on the charts. All one needed to know was how to read them.
THE LESSONS OF 2000If ever a year demonstrated how technical, intermarket, and economic analysis work together, 2000 was that year. Traditional technical indicators (likethe NYSE Advance–Decline line) had started breaking down over a year earlier. Stock market indexes started to crack during January 2000. Most stocktechnical indicators were giving “sell signals” during the spring of 2000. Intermarket warning signs had been flashing during the second half of 1999 in theform of rising commodity prices and rising interest rates. The result was around of Fed tightening that eventually resulted in an inverted yield curve,which has led to every recession since 1970. Sector rotation strategies followed the sequence that normally takes places at the end of an economicexpansion. 2000 was a textbook example of a stock market top and an economic top in the making. Yet, incredibly, most Wall Street professionals didnot see it coming—or pretended not to. This leads us to perhaps the biggestlesson of 2000, which is the need to use charts. Because, as the old-timersused to tell us, “Charts don’t lie.”
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Intermarket Picturein Spring 2003
FLIGHT TO GOLDBy the middle of 2002, the bear market in stocks was in its second year withno end in sight. Stocks were not the only asset class in a bear trend. Stockshad peaked during 2000. By the start of 2001, commodity prices had alsopeaked and entered a major decline of their own. Bond prices had been rising since the start of 2000. All three markets appeared to be following theirdeflationary script described in previous chapters. (During a deflation, bondprices rise while stocks and commodities fall.) The bond market was not theonly place in which to make money, however. Gold (and gold stocks) wererising for the first time in years. Part of the move into gold was a flight froma falling stock market. A large part of it, however, was also tied to a fall in theU.S. dollar. The dollar had been in a bull market since 1995. By the end of2000, the dollar stopped going up and started moving sideways.By the spring of 2002, however, the dollar rolled over and entered a newdowntrend. One of the key intermarket principles is that a falling dollar isbullish for gold. The dollar breakdown gave a big boost to gold and goldrelated shares. Another intermarket principle is that gold usually trends inthe opposite direction of the stock market. The combination of a falling stockmarket—and a falling dollar—lit a fire under gold (and gold stocks). A moresubtle intermarket influence was also present in the relationship betweengold bullion and gold stocks. Gold stocks turned up before bullion did. Intime, gold followed. However, as is usually the case, stocks tied to a certaincommodity (like gold) usually turn up before the commodity does. Risinggold stocks acted as a leading indicator for bullion.115
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CRB Index30-Year US Treasury Bond Price
© StockCharts.com 2003
12.5%10.0%7.5%5.0%2.5%0.0%-2.5%-5.0%-7.5%-10.0%-12.5%
Jul
Oct
FIGURE 8.1
Apr
Jul
Oct
Apr
Jul
Oct
Apr
Jul Oct
Apr
Bond prices and the CRB rose together during 2000, but diverged during2001. Bonds rose while commodities fell.
BONDS AND COMMODITIES TRENDIN OPPOSITE DIRECTIONSDuring 1999, commodity prices rose while bond prices fell. At the start of2000, however, bond prices started rising and remained strong for the nexttwo years. (The main reason for the strength in bonds during 2000 was amassive flight out of equities after the Nasdaq peaked that spring.) Commodity prices, which had been rising at the start of 2000, continued risinguntil the end of that year. After that, they collapsed. Bonds and commoditiesrose together during 2000. By the start of 2001, they had resumed their normal relationship, which is to trend in opposite directions. During 2001, bondprices rose while commodities fell as shown in Figure 8.1.
SEPTEMBER 11 REVERSALSA comparison of the CRB Index and bond prices from the middle of 2001 to themiddle of 2002 shows an almost perfect inverse relationship (see Figure 8.2).A dramatic demonstration of their inverse link was seen in the months sur-
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10.0%
CRB Index30-Year US Treasury Bond Price
7.5%5.0%2.5%0.0%-2.5%-5.0%-7.5%-10.0%-12.5%© StockCharts.com 2003
Jun
Jul
FIGURE 8.2
Aug
Sep Oct
Nov
Dec
Feb
Mar
Apr
May
Bonds prices and the CRB traded inversely from the spring of 2001 to thespring of 2002.
rounding the attack on the World Trade Center on September 11, 2001. In themonths leading up to September 11, bond prices had been rising while commodity prices had been falling. After that day, both markets changed direction within a week of each other but continued moving in opposite directions.The CRB Index bottomed on October 24; bond prices peaked on November 1.The stock market played an important role in both reversals.
COMMODITIES FOLLOW THE LEAD OF STOCKSThe CRB Index and the S&P 500 rose together during 1999 and part of 2000,before falling together throughout most of 2001 (although stocks peakedbefore commodities). They bottomed together after September 11 (see Figure8.3). Although it is true that stock and commodity prices often trend in opposite directions, it is also true that they sometimes trend together. It depends onthe position of the business cycle. At the end of an economic expansion, commodity prices rise along with stocks and eventually contribute to the stockmarket peak. Commodity prices can then keep rising after stocks peak (whichthey did during the second half of 2000). During a recession, commodityprices fall along with stocks. Commodities can keep falling long after stocks
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© StockCharts.com 2003
CRB IndexS&P 500 Large Cap Index
40.0%35.0%30.0%25.0%20.0%15.0%10.0%5.0%0.0%-5.0%-10.0%-15.0%
Jul
Oct
FIGURE 8.3
Apr
Jul
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Apr
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Oct
Apr
Jul Oct
Apr
Commodities bottomed after stocks in 1999 and peaked after stocks at thestart of 2001.
have bottomed. (We’ll discuss why that happens in a later chapter.) In bothinstances, however, stocks usually change direction before commodities.In 1999, rising commodity prices lifted inflation expectations, whichcontributed to the stock market peak in 2000. In 1999, both markets rosetogether. While the Nasdaq market peaked during the spring of 2000, the S&P500 did not peak until autumn (around Labor Day). The CRB Index continuedrising for another three months before finally turning down at the start of2001. This action is consistent with the order usually seen at stock marketpeaks: stocks peak first and commodities second. In 2001, stocks and commodities fell together—until September 11.
STOCKS LEAD COMMODITIES HIGHERPrior to September 2001, stocks and commodities were both dropping. Afterthe September 11 attacks, the stock market remained closed for a week.When trading resumed on September 17, the stock market initially fell forseveral days. Within a week, however, the market rallied sharply in an intermediate recovery that lasted into the following spring. Commodities followedstocks higher, as shown in Figure 8.4.
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5.0%
CRB IndexS&P 500 Large Cap Index
2.5%0.0%-2.5%-5.0%-7.5%-10.0%-12.5%-15.0%-17.5%-20.0%© StockCharts.com 2003
Jun
Jul
FIGURE 8.4
Aug
Sep Oct
Nov
Dec
Feb
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-22.5%
May
Commodities and stocks traded in tandem from the spring of 2001 to thespring of 2002. Both turned up after September 11.
A comparison of stocks and commodities after September 11 is instructional on two counts. One is that both markets rallied. Another is that commodities bottomed a month after stocks did. In other words, they followedtheir normal rotational pattern of commodities following stock prices. TheDow Jones Industrial Average bottomed on September 24, 2001. The CRBIndex bottomed on October 24. The rebound in stock prices after September11, and the resulting bounce in commodity prices, also explains the drop inbond prices that took place around the same time. Bonds had been rising,while stocks and commodities had been falling. These roles reversed, at leastfor awhile (see Figure 8.5). (The unusually close link between stocks andcommodities and the inverse relationship of both to bonds were the result ofdeflationary pressures. In such an environment, stocks and commodities falltogether, while bond prices rise.)
BOND AND STOCK PRICES TREND IN OPPOSITE DIRECTIONSAs previously mentioned, the inverse relationship between bonds andstocks represents the biggest change in traditional intermarket relation-
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10.0%
CRB IndexS&P 500 Large Cap Index30-Year US Treasury Bond Price
7.5%5.0%2.5%0.0%-2.5%-5.0%-7.5%-10.0%-12.5%-15.0%-17.5%-20.0%© StockCharts.com 2003
Jun
Jul
FIGURE 8.5
Aug
Sep Oct
Nov
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Feb
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Apr
-22.5%
May
The T-Bond peak after September 2001 followed bottoms in the CRBand the S&P 500.
ships. History has shown that bond and stock prices rise and fall together,except at major turning points. At major tops, bonds turn down beforestocks. At major bottoms, bonds turn up before stocks. This is why risingbond prices are normally bullish for stocks. When deflation is a threat, however, this decoupling can last for several years. In such an instance, risingbond prices are actually bad for stocks. By the middle of 2001, bond andstock prices had been traveling in opposite directions for more than threeyears. Bonds had been going up and stocks had been going down—untilSeptember 11 (see Figure 8.6).
SEPTEMBER 11 REVERSES TRENDSStocks bottomed during the last week of September 2001. Bonds peaked onthe first day of November (about five weeks later). Stocks continued torise—while bonds fell—into the spring of the following year. After that,bonds resumed their long-term uptrend; stocks eventually fell to new bearmarket lows. Throughout these traumatic months, the inverse relationshipbetween bonds and stocks held fast (see Figure 8.7).
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© StockCharts.com 2003
S&P 500 Large Cap Index30-Year US Treasury Bond Price
35.0%30.0%25.0%20.0%15.0%10.0%5.0%0.0%-5.0%-10.0%
Jul
Oct
Apr
FIGURE 8.6
Jul
Oct
Apr Jul
Oct
Apr Jul Oct
Apr
Bonds and stocks traded in opposite directions from 1998 to 2002. Startingin 2000, bonds rose while stocks fell.
10.0%
S&P 500 Large Cap Index30-Year US Treasury Bond Price
7.5%5.0%2.5%0.0%-2.5%-5.0%-7.5%-10.0%-12.5%-15.0%-17.5%-20.0%© StockCharts.com 2003
Jun
Jul
FIGURE 8.7
Aug
Sep Oct
Nov
Dec
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Apr
-22.5%
May
Bonds and stocks changed direction after September 11, 2001 but continuedto trend in opposite directions.
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S&P 500 Large Cap IndexUS Dollar Index
5.0%0.0%-5.0%-10.0%-15.0%-20.0%-25.0%-30.0%-35.0%
© StockCharts.com 2003
F M
A
FIGURE 8.8
M
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S O
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F M
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A
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The dollar and stocks started falling together at the start of 2002.
The dollar was tracking the stock market closely in 2001. Both had beenfalling together in the months prior to September 11. Both bottomed togetherthat month and stayed in sync on the upside until the following spring. Thedollar actually bottomed on September 20, 2001, four days before stocks did,as shown in Figure 8.8. Stocks then resumed their bearish trend, while thedollar started a bear market of its own. There is one market that reallyshines when stocks and the dollar are in bear markets together—and thatmarket is gold.
FALLING STOCKS ARE GOOD FOR GOLDGold peaked in 1980 over $700 and had been falling for 20 years. The stockmarket bottomed during 1982 and rose for the next two decades, which isconsistent with the intermarket principle that gold and the stock market usually trend in opposite directions. The S&P 500 peaked near the end of August2000. Gold stocks bottomed within two months (in November 2000) andstarted an impressive bull run. (Gold bullion did not turn up until April of the
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following year. It is normal for the shares to turn up before the commodity.)A new bear market in stocks helped usher in a new bull market first in thegold shares and then in gold itself (see Figure 8.9).At that point in time, some skeptics questioned the staying power of therise in gold shares on the grounds that gold was an inflation hedge andthere was more deflation than inflation. However, gold shares have historically done well during both inflations and deflations. The inflationary periodof the 1970s saw strong gold shares (and a soaring gold market). Althoughgold bullion was set at a fixed price during the deflationary years from 1929to 1932, the price of Homestake Mining (a gold stock) gained 300 percentwhile the stock market lost close to 90 percent of its value. (The 1929–1932deflation also saw rising bond prices with falling stocks and commodities,much like the recent situation.) Gold is considered an alternative to paperassets. No one needed the insurance of gold during the big bull market instocks. It is no accident, then, that the end of the 20-year bull market in stockscoincided almost exactly with the ending of the 20-year bear market in gold.Gold had another thing going for it besides a falling stock market, and thatwas a falling dollar.
S&P 500 Large Cap IndexGold & Silver Index
30.0%20.0%10.0%0.0%-10.0%-20.0%-30.0%-40.0%© StockCharts.com 2003
Apr
FIGURE 8.9
Jul
Oct
Apr
Jul
Oct
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Jul
Oct
Apr
A new bear market in the S&P 500 helped usher in a new bull market in goldshares and gold bullion.
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MAY 22, 2002: MAJOR DOLLAR TOP IN THE MAKINGThis headline is taken from a Market Message posted on the MurphyMorris.comwebsite on May 22, 2002. A number of technical indicators were shown tomake the point that the dollar looked to be making a major top. The last sentence in the opening paragraph concluded: “All are bearish indications forthe greenback.” From the fourth quarter of 2000 to the first quarter of 2002, theDollar Index had formed three major peaks. (The technical name for that typeof pattern is a head and shoulders top.) In April 2002, the Dollar Index broke atrendline drawn under the two troughs formed during January and September2001. This was the chart signal that the topping pattern had been completed forthe dollar; it indicated the start of a major decline (see Figure 8.10).
FALLING DOLLAR IS BULLISH FOR GOLDHistorically, the primary beneficiary of a falling dollar is the gold market andgold mining shares. There usually exists an inverse relationship between the
US Dollar IndexMoving Average (10 weeks)Moving Average (40 weeks)
122.0120.0118.0116.0114.0112.0110.0108.0
© StockCharts.com 2003
J
J
A S O
FIGURE 8.10
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106.0
M
The U.S. Dollar Index broke a support line in April 2002, which completed amajor top formation.
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US Dollar IndexGold - Continuous Contract
22.5%20.0%17.5%15.0%12.5%10.0%7.5%5.0%2.5%0.0%-2.5%© StockCharts.com 2003
Oct
Apr
FIGURE 8.11
Jul
Oct
Apr
Jul
Oct
Apr
Jul
The drops in the dollar during 2001 and 2002 contributed to an upturn ingold bullion.
dollar and gold, meaning that they trend in opposite directions. If gold bullionwas about to rise in the spring of 2002, it was normal to expect that goldshares would rise even faster. The following statement was made in May2002: “And since gold stocks usually rise faster than the price of bullion—gold shares remain our favorite play.”A chart comparing the dollar to gold prices from 2000 to 2002 showstheir inverse link (see Figure 8.11). The gold market had started rallying during the spring of 2001 after the dollar had formed the first of its three peaksa few months earlier. Six months into 2001, the dollar formed the second ofits three peaks, coinciding with another rally in gold. The third and final dollar peak took place in February 2002. This gave the new uptrend in gold aneven bigger boost. By the spring of 2002, the dollar was in a major decline andgold had climbed back over $300 for the first time in two years.
GOLD STOCKS SHINEGold stocks bottomed several months ahead of bullion. The actual bottom inthe Gold Index (XAU) took place during the fourth quarter of 2000, just as the
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dollar was forming the first of its three peaks. By the time the dollar had completed its third peak during the spring of 2002, the Gold Index had alreadyrisen to the highest level since the fourth quarter of 1999. (Chart 8.12). Goldand gold shares had done exactly what an intermarket chartist would haveexpected them to do at that point. The combination of a major decline in thedollar and a major top in the stock market had historically proven to be bullish for the gold sector. Figure 8.12 shows the new uptrend in gold sharesbeing helped by a weaker dollar.Some traders took the view that gold was not much of an investmentbecause it had done so poorly for 20 years. However, this was one of the mostcompelling reasons why gold (and its shares) had become such a good investment. The two-decade bull market in stocks had ended. What better time tobuy gold? Consider the alternatives. Stocks were in a major decline. Interestrates had fallen to the lowest level in 40 years, making fixed income investments less attractive. Twelve Fed easings since the start of 2001 had pushedU.S. short-term rates to the lowest level among the major industrialized countries with the exception of Japan (whose rates were at zero). Money marketfunds were paying little more than 1 percent. With U.S. rates so much lower
25.0%
US Dollar IndexGold & Silver Index
20.0%15.0%10.0%5.0%0.0%-5.0%-10.0%-15.0%-20.0%-25.0%-30.0%-35.0%© StockCharts.com 2003
Apr
FIGURE 8.12
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Oct
Apr
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The bottom in gold shares coincided with a top in the dollar.
Jul
-40.0%
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than they were in other countries, the dollar had nowhere to go but down.This made U.S. bonds and stocks even less attractive to foreign investors. Aclimate of falling stock prices, a falling U.S. dollar, and historically low interest rates do not leave people with a lot of investment alternatives. This is theexact type of intermarket climate that drives money to gold.
ONE YEAR LATER: THE FED DISCOVERS DEFLATIONIntermarket trends since the Asian currency crisis in the middle of 1997 hadbeen hinting at a growing deflationary threat. In fact, the only intermarketmodel that made any sense after 1997 was based on deflation. The markets,which are discounting mechanisms, had already been trading for severalyears based on the assumption that the deflation threat was for real. Meanwhile, the economic community (including the Fed) kept referring to fallinginflation and falling interest rates as good things. It took more than five yearsafter the 1997 Asian crisis (and the worst bear market in stocks since thedeflationary 1930s) for it to happen. In the spring of 2003, however, the Fedfinally expressed some concern about the threat from falling prices.On Tuesday, May 6, 2003, the Federal Reserve announced its decision toleave short-term rates unchanged at the 1.25 percent level. This was expected.What was unexpected was the statement released the same day that “theprobability of an unwelcome substantial fall in inflation, though minor,exceeds that of a pickup in inflation from its already low level.” Although it didnot