ural exports isattributed to variations in exchange rates. The 1985 figure was 25 percent.This probably explains why agricultural commodity markets had such a goodyear in 2002 when the dollar started to fall to the lowest level in years.
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Another sign of growing global awareness is heavy money flows into emerging markets in recent years.
EMERGING MARKETSSince interest rates started to plunge three years ago, emerging-market bondshave done extremely well for global investors. Some of the biggest gains havecome from Brazil, Mexico, and Russia. Since the 1997–1998 global currencycrises in Asia and Russia, emerging-market bonds have gained 134 percent.Since 2001, Russian bonds have returned an impressive 66 percent. Americaninstitutional investors were attracted to emerging-market bonds because oftheir high yields at a time when stock markets were dropping and U.S. bondyields were falling to the lowest levels in over 40 years. By the middle of 2003,however, there were early signs that a global rotation was starting to take placeout of bonds and into stocks. Here again, leadership came from emergingmarket stocks.During the first six months of 2003, the Morgan Stanley Capital International Emerging Markets Global Index gained 15.9 percent. This compareswith an 11.1 percent return for developed markets over the same period. Twoof the factors contributing to the better performance in stock markets ofdeveloping countries were a weaker U.S. dollar and stronger commoditymarkets. For one thing, the weaker dollar increased the profitability of foreign markets to American investors. The weaker dollar also boosted the valueof global commodities, which are priced in dollars. Higher commodity pricesincrease the bottom line of developing countries that are commodity exporters. Mexico and Russia, for example, are exporters of oil and benefit fromrising energy prices. Russia exports more oil than any other country with theexception of Saudi Arabia.In dollar terms, some of the top global performers during the first half of2003 were Argentina (+65 percent), Brazil (+44 percent), Indonesia (+34 percent), Russia (+28 percent), New Zealand (+20 percent), and Taiwan (+18percent). These strong overseas gains compared with U.S. returns of 13 percent in the S&P 500 over the same time span. Three of the biggest developingcountries showing high growth were China, India, and Russia. (During thefirst half of 2003, the Chinese GDP had grown by 8 percent with especially biggains in manufacturing. Growth in China is good for the global economy,especially Asia. China has become the biggest importer of goods produced inthe rest of Asia, including Japan.) Gains in Asian stock markets (like South
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Korea’s) during the first half of 2003 were closely tied to a revival of technology stocks as evidenced by a 30 percent gain in the Nasdaq market. Twentyyears ago, American investors were just discovering a valuable lesson: foreign markets offer profit opportunities outside of America’s borders. Judgingfrom the strong performance of emerging-market bonds and stocks andstrong money flows into these markets, that lesson has been well learned.
MORE INTERMARKET EMPHASIS ON SECTOR WORKMy initial intermarket writing focused mainly on the four market groups—bonds, stocks, commodities, and currencies—and how they relate to eachother. This is still very important. Over the years, however, more emphasishas been put on intermarket sector work. With the proliferation of Exchange Traded Funds (ETFs), traders are able to slice the market up intosmaller parcels in a way that was impossible just a few years ago. Intermarket work plays an important role in sector and industry group rotation.Sector work even plays a role in individual stock selection. It has been estimated that 50 percent of a stock’s trend is determined by the sector (orindustry group) in which it is found. So if you are looking for a winningstock, find a winning group first. Then pick the strongest stock in that group.Understanding which market sectors do best at different stages of the business cycle is another breakthrough in intermarket work.Proper asset allocation has become much more important over the pastfive years. Investors need to have the proper tools to adjust their asset allocation mix to suit market conditions. Those investors who had the foresightto move out of stocks and into bonds in 2000 saved themselves an awful lotof money. Those who moved some money into REITs or gold funds also didquite well while the stock market was falling. The technical tools employedin intermarket analysis are extremely helpful in making the proper assetallocation adjustments.
THE INTERMARKET MODEL IS NOT STATICOne of the most important lessons to be learned in studying the past fiveyears is that the intermarket relationships outlined in this book are not static.Sometimes they stop working for a period of time before kicking back in
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again. At times, a lag can exist before a turn in one market starts to exert itsinfluence on another. Sooner or later, however, things have a way of returning to normal. The trick is to recognize when the correlations among marketsare working and are exploitable. When they are not working, it is best to givethem less weight in one’s analysis until correlations start to strengthen again.While most of the lapses in intermarket correlations are temporary, there aresome instances where major changes do take place in a traditional intermarket relationship. This was the case with bonds and stocks.
BONDS AND STOCKS DECOUPLEThe biggest change in an intermarket relationship over the past five years hasbeen the major decoupling of bonds and stocks that started in the 1997–1998period. We now know that it was the result of deflationary pressures notseen since the Great Depression. It took a lot of people a long time to recognize that a major change had taken place in the bond-stock relationship, andeven longer to understand why. The decoupling of bonds and stocks over thepast five years was not completely new. It happened the last time the worldwas faced with a deflationary problem. It was not a case of a key relationshipno longer working. The relationship between bonds and stocks had revertedto a similar pattern that existed during the 1930s. Those investors who recognized the deflation threat earlier on, and who understood that bonds goup while stocks go down in such an environment, were prepared for marketchanges after 2000.
WHY WE NEED TO STUDY HISTORYMy first intermarket book examined market trends after 1970. The intermarket relationships described in that earlier text remained pretty constantfrom the 1970s through the end of the 1990s. Events over the past five years,however, have demonstrated the need to look much further back in time toget a better grasp of intermarket relationships that existed in different economic eras. History does tend to repeat itself. This book examines a verylarge time span in order to provide a better historical perspective on currenttrends. Although the news may not always be good, it is reassuring to knowthat it has happened before.
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Dow Jones Industrial Average
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Shows bear markets during the 1930s and 1970s.
History tells us that stock market booms are usually followed by a longperiod of stock market underperformance. Figure 15.1 shows that the twoprevious stock market booms took place during the 1920s and the 1960s. Bothwere followed by at least a decade of subpar stock market returns. Since thelast boom peaked in 2000, history warns us not to expect anything resemblingthe strong market of the 1990s anytime soon. Figure 15.1 shows the majordecline in the stock market during the 1930s, and the sideways action thatcharacterized the 1970s. Both of these weak decades followed big stock market booms. Having ended the third stock market boom of the last century justthree years ago, this doesn’t augur well for the current decade.
THE DECADE AFTER MARKET BOOMS ARE NOT VERY GOODIt is always dangerous to compare two different market eras. No two erasare ever exactly alike. Figure 15.2 shows what happened after the majoreconomic expansion of the 1960s ended. The stock market peaked in 1966and traded in a huge sideways fashion until 1982. This difficult period lasted
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FIGURE 15.2
A closer look at the 1970s.
16 years. The worst loss was suffered in 1973 and 1974 when the S&P 500lost half its value. Although it bottomed near the end of 1974, it was not until1982 (eight years later) that the market began another secular bull trend.During the Great Depression, the stock market hit bottom in 1932. It tookanother 22 years (until 1954) from that bottom for the market to exceed thehighs hit during 1929. Measured in constant dollars (meaning that the returnsare adjusted for inflation), the period from the mid-60s to 1982 was just asdamaging as the 1930s.Figure 15.3 shows the Dow Jones Industrial Average in constant dollars.This does not affect the 1930 collapse since deflation was the main problemduring that era. Because the 1970s were marked by hyperinflation, however,the returns on the stock market during that decade look much worse whenadjusted for the higher inflation. Measured against inflation, the decline inthe Dow from the mid-60s to the early ’80s looks almost as bad as it did in the1930s. In some ways, the 1970s were worse than the 1930s. During the Depression, stocks bottomed only three years after the 1929 peak. During the 1970s,the inflation-adjusted value of the Dow fell for 16 years before turning up inthe early 1980s. A closer examination of the 1930s shows the stock market
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FIGURE 15.3
When adjusted for inflation, the decline in the Dow during the 1970s looks almostas bad as the 1930s.
recovering from 1932 to 1937. After that, however, the Dow lost ground foranother 16 years. It took until 1954 for the inflation-adjusted value of theDow to exceed its 1937 peak. This was 25 years after the stock market boomended in 1929.The reason for our examination of these two prior eras is to demonstrate that the decade (or two) after the end of a stock market boom is usually characterized by relatively trendless action. That does not bode well forthe coming decade, although it does not mean that money cannot be madein the stock market in the coming years. The important thing is to recognizethat the next decade will probably look much different than the last twodecades; there will be a need to adjust to the new market environment. Itwill require a different philosophy, a different set of tools, and a differenttime horizon.There is always money to be made in the stock market. The problem isthat investors will probably have to work harder to make it over the nextdecade. The buy and hold approach that worked so well over the past 20years probably is not going to work as well over the next several years.
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Investors will need to take a more proactive approach to investing. Bull andbear moves will be shorter in duration. There will be times to buy and timesto sell. Simply “holding on” will not work. Successful investing is going torequire more skill at market timing.Sector trading should become even more important in the coming yearsthan it already is. When the market was going up in the 1990s, sector workwas not as important. All one needed to do at that time was buy an index fundthat tracked the entire market. Sector work was also less important in thethree years after 2000 when most sectors fell. In the new market environmentthat will probably be marked by smaller trends, however, some sectors willundoubtedly do better than others. The difficult part will be learning how tospot the group leaders as soon as possible and rotating into new leaderswhen the old leaders start to stumble. Needless to say, most of these timingtools that will be needed to do this are technical in nature. This means thatsome knowledge of technical analysis will be more important than ever.
INTERMARKET IMPLICATIONS FOR TECHNICAL ANALYSISBecause intermarket work involves looking at so many markets, it has to bedone with price charts. Chart analysis is the easiest and most efficient wayto study intermarket linkages. It greatly expands the usefulness of technicalanalysis. It allows analysts like me to talk about things that used to berestricted to security analysts and economists. Some understanding of howbonds, stocks, and commodities rotate in the business cycle allows us to talkabout the state of the economy. Sector rotation also sheds light on whetherthe economy is expanding or contracting.The financial markets are leading indicators of economic trends. It tookthe Federal Reserve until the spring of 2003 to acknowledge the threat ofdeflation. The markets had spotted the threat years earlier. The events surrounding the stock market peak in 2000 also demonstrated the need to incorporate some chart analysis into economic and fundamental forecasting. Ittook the Wall Street fundamental community a long time to find out whatchartists already knew during the first half of 2000. The stock market hadpeaked and the economy was in trouble. It has often been said that technicalanalysis is just a shortcut form of fundamental analysis. It is based on theidea that price action is a leading indicator of a market’s fundamentals. A lotof Wall Street analysts (and their clients) learned the danger of ignoring thechart signals that the markets gave off in 2000. They learned the danger ofignoring intermarket signals as well.
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THE NEED FOR BETTER PERIPHERAL VISIONThe greatest contribution made by intermarket analysis is that it improvesthe market analyst’s peripheral trading vision. Trying to trade within themarkets without intermarket awareness is like trying to drive a car withoutlooking at the side and rear view mirrors. In other words, it is very dangerous. The application of intermarket analysis extends to all markets everywhere on the globe. By turning the focus of the market analyst outwardinstead of inward, intermarket work provides a more rational understandingof forces at work in the marketplace. It provides a more unified view ofglobal market behavior. Intermarket analysis uses activity in surroundingmarkets in much the same way that we use traditional market indicators.Intermarket analysis does not replace traditional market analysis; it addsanother dimension to it.
INTERMARKET WORK IS AN EVOLUTIONARY STEPTechnical work has many applications beyond the traditional study of isolated charts and internal market indicators. I like to think that intermarketanalysis represents another step in the evolution of technical theory andpractice. With the growing recognition that all markets are linked—financialand nonfinancial, domestic and international—traders can take these linkages into consideration more and more in their analyses. Because of its flexibility and its universal application to all markets, technical analysis isuniquely suited to perform intermarket work.Intermarket analysis provides a more useful framework for understanding how individual markets and sectors relate to one another. Throughoutmost of the twentieth century, technical analysis had an inward focus. Thenew century has already started to witness a much broader application oftechnical principles in the areas of economic and financial forecasting. Eventhe Federal Reserve has learned to look to the financial markets to get cluesabout the future course of the economy. It uses charts to do this. The principles presented in this book offer a much broader view of the future of technical analysis. I think it is a bright one. And I believe intermarket analysis willplay an increasingly important role in that bright future.To ignore these interrelationships is to miss enormously valuable priceinformation. What is worse is that it leaves market analysts in the position ofnot understanding the external forces that are moving the market in which
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they are trading. The days of following only one market are long gone. Market analysts need to know what is happening in all of the financial marketsand must understand the impact of trends in related markets all over theglobe. Technical analysis has enormous transferability in moving from onemarket to another and is extremely useful in comparing these markets’ relative performance.
THERE IS STILL A LOT TO LEARNIn concluding the introduction to my earlier book on intermarket analysis, Iwrote that the material presented was a “beginning rather than an end.” Thisis even more true today than it was then. As I said at the time, there is stilla lot that remains to be done before we can fully understand how marketsrelate to one another. And just when it seems like we have it all figured out,something changes. This is what happened with bonds and stocks. Nothingchanges, however, in a vacuum; there is usually a reason for the change.The changing relationship between bonds and stocks signaled that the recentdownturn in the business cycle would be different from other downturnssince World War II.The intermarket principles described in this book are presented as guidelines, not rigid rules. The ability to adapt to changing market circumstancesis one of the keys to survival and profitability. This is true in intermarketwork just as it is in any other form of market analysis. Although the scope ofintermarket analysis is broad, forcing us to stretch our imaginations andexpand our vision, I remain excited about the prospects for its future. It isfertile ground for market research and profitable trading opportunities.
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he start of October 2003 marked the one-year anniversary of thestock market bottom that had formed twelve months earlier. Fromthe first week of October 2002 to the same week a year later, theDow rose 24 percent while the S&P 500 gained 26 percent. The two bestperforming market averages, however, were the Nasdaq Composite Index(+61 percent) and the Russell 2000 small-cap Index (+43 percent). That carried good news for the market. That’s because leadership by small caps andtechnology is a sign of market strength. Sector results were also encouraging. Technology gained 58 percent to take the top spot. The three other market sectors that outperformed the S&P 500 over the prior twelve monthswere Financials (+32 percent), Basic Materials (+27.3 percent), and Consumer Discretionary (27 percent).The strong performance by Basic Materials reflected rising industrialcommodity prices, which is a sign of economic strength. So is the relativestrength in Consumer Discretionary stocks. Their strong performanceshowed rising consumer confidence, which is an important ingredient in aneconomic recovery. The gains in the Financials came mainly from brokeragestocks, which were among the top industry group performers (+78 percent).Brokerage stocks are viewed as a leading indicator for the rest of the stockmarket. Two other leading industry groups were the Internet (+120 percent)and semiconductors (+92 percent). It’s a good sign for the technology sectorwhen the semiconductors are in a leadership role. During the third quarterof 2003, precious metals funds gained 24 percent and were that quarter’s topperformer. Technology funds came in second with a gain of 10 percent. Realestate funds were third with a rise of 9 percent.
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2003 GLOBAL TRENDSAsia was the top performing region during the first three quarters of 2003(gaining 26 percent in dollar terms). By comparison, North America gained 15percent while Europe came in last at 14 percent. The stronger performanceby Asian markets was also seen during the third quarter of 2003. Japan gained21 percent to take the top spot among global stock markets. Emerging markets rose 14 percent during the third quarter to also maintain a 2003 leadership role. A lot of the strength in Asia came from semiconductors, whichwere the top global sector during the first three quarters of 2003 (rising 23percent). Asia is closely tied to trends in the semiconductor industry. Thesecond best global sector during the third quarter was non-ferrous metals.That’s mainly copper and aluminum stocks. A lot of the buying in those commodities was tied to the rising tide in Asia.
CHINA BUYS COMMODITIES FROM LATIN AMERICAOn Monday, September 29, 2003 the Wall Street Journal ran a story entitled“Latin America Gets Unexpected Boost from China’s Success”. The articlediscussed how China’s need to feed its large population and its search forbasic materials to fuel its huge manufacturing economy was benefiting LatinAmerica. The Chinese purchase of copper and gold from Chile and Peruboosted the prices of those commodities and helped both economies. Chinese buying of beef from Argentina and soybeans from Brazil had the samebeneficial effect on those two countries, and partially explains the strongperformance by those two agricultural commodity markets during 2003. Thearticle suggested that buying from China and the rest of Asia could producea Latin American “export led” recovery over the next few years. That’s anexample of why stronger commodity prices are usually associated withstronger emerging markets.
INDUSTRIAL METALS LEAD COMMODITY RALLYDURING 2003A study of how the various commodity markets did during the first threequarters of 2003 carried some positive economic news. That’s because thetop performing commodity group was Industrial Metals with a gain of 14 per-
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cent. This is the group most closely tied to the trend of the global economy.During 2002, the commodity rally was led by agricultural markets, energy,and precious metals. During 2003, the commodity rally was led by economicallysensitive industrial metal markets. Another good sign for the economy wasthe fact that energy prices lost 2 percent during the first nine months of 2003and were the weakest of the commodity groups.
2003 INTERMARKET TRENDS FAVOR STOCKSAND COMMODITIESIt’s also instructive to compare the prior year’s relative performance of the fourmarkets that form the primary basis for intermarket analysis. In the twelvemonths after October 2002, the stock market was the top gainer (with the S&P500 up 26 percent). Commodities came in second with a CRB Index gain of 8percent. The strong performance by those two markets was reflective of animproving economic picture around the globe. Earlier in the book, I talkedabout the reasons why rising commodity prices were good for stocks comingout of a deflationary environment. Stocks and commodities rose together inthe early 1930s and signaled that deflationary pressures were easing. Theydid the same during 2003. Bonds and the U.S. dollar lost ground during 2003.Bonds lost 4 percent in the twelve months after the stock market bottomed inOctober 2002. Improving economic conditions during 2003 contributed to arotation out of bonds and into stocks. That reversed the trend seen during the2000–2002 bear market when investors bought bonds and sold stocks. The newtrend was more consistent with economic growth. The U.S. dollar was theworst of the four markets and lost 12 percent over the prior year. I suggestedearlier in the book that the U.S. government was deliberately weakening thedollar to combat deflationary tendencies in the U.S. economy and in anattempt to reinflate the economy. Much of the upward movement in commodities (and gold in particular) over the prior year could be directly tracedto the falling U.S. currency. If there was any doubt that the American government wanted a weaker dollar, that doubt was erased during the Group ofSeven meeting that took place during September 2003.
MOVE TOWARD FLEXIBLE EXCHANGE RATES BOOSTS YENOver the weekend of September 20–21, G7 finance ministers released a statement calling for flexible exchange rates in currency markets. It was clear that
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the statement was aimed at Asian countries that had been intervening in theforeign exchange markets to keep their currencies from rising. A month earlier the Chinese government had rejected international pressure to allow theyuan to rise to a more reasonable market value. That pressure came from theU.S., but was supported by Japan. The immediate result from the G7 meetingin September 2003 was a jump in the yen versus the dollar to the highest levelin three years. It was interesting to see how the world markets reacted.Global stock markets tumbled the first day after the news. The Japanesestock market lost 4 percent on fears that a rising yen would hurt exports.European markets dropped 3 percent on fears that a rising Euro would havethe same negative effect on their markets. The U.S. stock market lost a littleover 1 percent. The dollar dropped sharply and gold prices jumped to aseven-year high. The rise in the Japanese yen was reflective of an improvingJapanese economy, rising Japanese interest rates, and strong money flowsinto Asian stock markets. The new currency policy, however, could be amixed blessing.The United States wanted a weaker dollar to boost exports and createjobs in the American manufacturing sector. A weaker dollar makes U.S.goods more attractive to foreigners. The weaker dollar, however, carriedsome potential problems. During July, Chinese and Japanese holdings ofU.S. Treasuries had risen to a new record. In the third quarter of 2003, theJapanese central bank was the largest foreign holder of U.S. Treasuries.The Japanese had been buying U.S. dollars in an attempt to keep the yenfrom rising. They re-invested those dollars in U.S. Treasuries. The new fearwas that the Japanese would buy fewer dollars in the future, which couldresult in less buying of Treasuries. That could result in higher U.S. interestrates, which could threaten the budding American economic recovery.Once again, trends in the currency markets had a potential bearing on thedirection of interest rates and stock prices here in the United States andelsewhere.
STRONG SEPTEMBER JOBS REPORT BOOSTS STOCKSBUT HURTS GOLDAnother demonstration of intermarket linkages took place on Friday, October 3, 2003. Going into that morning, stock prices had been correcting downward while bond prices were rallying. The dollar was testing its low for theyear, while gold prices were flirting with seven-year highs. At 8:30 A.M. (NYT),
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surprisingly strong employment numbers were reported. The American economy had created new jobs for the first time in eight months. That caused animmediate (but predictable) intermarket reaction in the four markets. Thestock market jumped strongly and bond prices fell sharply; the dollar ralliedwhile gold prices fell heavily. There’s no way to judge at this time the longerrange consequences of that strong jobs report or the longer-range implications of the new flexible exchange rate policy. In both instances, however,the immediate reactions of the four markets were in line with their normalintermarket pattern. Some went up and some went down. But each of themdid what it was expected to do. The trends of the individual markets maychange, but their intermarket relationships usually stay pretty constant. Profiting from those relationships is what this book is all about.
OCTOBER 2003 CHARTSThe remaining pages show charts of the major markets through the end ofthe third quarter 2003. Generally speaking, they paint a more optimistic picture of global market trends. Stocks are stronger and bonds are weaker thanthe prior year. While the weak dollar carries some potential negative sideeffects, it has also given a big boost to commodity markets like gold and, inso doing, diminished deflationary pressures. Deflation appears to be givingway to reflation. The world’s deflationary problems started with the Asiancurrency crisis during 1997. It seems only fitting that 2003 saw Asia leadingthe world away from deflation. The charts in the Appendix are market snapshots taken at a given point in time. Charts become obsolete, however, asmarket trends change. What doesn’t change is the fact that all of these markets are linked to one another. That’s the main message to be learned fromintermarket analysis.
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Figure A.1After peaking during the spring and summer of 2002, the REIT sector underwent a downside correction and underperformed the S&P 500 for more than ayear. During September 2003, however, the Dow Jones REIT Index exceededits 2002 peak to reach a new high. The REIT/S&P 500 ratio also turned higherduring the third quarter of 2003, which suggested new leadership by REITs.The REIT Index has traded over its 10-week average since March, which isanother sign of strength.
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Dow Jones REIT IndexMA(