it is important thatthe price of gold rises faster than foreign currency markets. This brings usback to ratio analysis.
GOLD/CURRENCY RATIOS ARE RISINGFigures 11.9 through 11.11 show a ratio of the dollar price of gold divided bythe British pound, the Canadian dollar, and the Japanese yen. The fact that allthree ratios have risen since the end of 1999 means that gold has risen fasterthan all three currencies. This is what should happen if the rally in gold is trulyglobal. Figure 11.12 shows that gold has also outperformed the euro from theend of 1999. To the far right, it can be seen that gold dropped in euro termsfrom the spring of 2002 to the spring of 2003. However, the major trend overthe entire three years has been upward.
Gold / British Pound Ratio
2.302.252.202.152.102.052.001.951.901.851.801.751.701.651.60© StockCharts.com 2003
A J O
FIGURE 11.9
A J O
A J O
A
J O
A
J O
A J
O
The rising ratio shows that gold has risen faster than the poundsince late 1999.
A
J
1.55
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Gold / Canadian Dollar Ratio
© StockCharts.com 2003
A
J O
FIGURE 11.10
A J
O
A J
O
A
J O
A
J O
A
J
O
A
© StockCharts.com 2003
FIGURE 11.11
J
The rising ratio shows that gold has outperformed the Canadian dollarsince late 1999.
Gold / Japanese Yen Ratio
A J O
5.75.65.55.45.35.25.15.04.94.84.74.64.54.44.34.24.14.03.93.83.7
A J O
A J O
A J O
A J O
A J
O
450.0440.0430.0420.0410.0400.0390.0380.0370.0360.0350.0340.0330.0320.0310.0300.0290.0280.0270.0
A J
The rising ratio shows that gold has risen faster than the yen since late 1999.
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3.6
Gold / Euro Ratio
3.53.43.33.23.13.02.92.82.72.62.52.4© StockCharts.com 2003
Apr Jul Oct
FIGURE 11.12
Apr Jul Oct
Apr Jul Oct
Apr Jul Oct
2.3
Apr Jul
Gold has risen more than the euro since mid-1999.
GOLD IS STRONGER THAN ALL MAJOR CURRENCIESFigure 11.13 overlays the price of gold (in dollar terms) versus the world’stwo biggest foreign currencies—the euro and the Japanese yen—since 1999.It shows all three lines rising. The euro has risen faster than the yen. However, gold has risen faster than both foreign currencies. The value of the euroand the yen have been falling relative to gold since the end of 1999. This hasbeen especially true since 2001 when the returns on both currencies turnednegative relative to gold. The British pound, Canadian dollar, and Swiss franchave also been falling relative to the dollar price of gold.
SUMMARYThis chapter utilizes ratio analysis to better monitor the relationship betweencommodities (the CRB Index) and bonds and stocks—and between bondsand stocks only. Ratio analysis provides a useful technical tool for spottingtrend changes in these intermarket relationships. Trendline analysis can be
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35.0%
Gold - Continuous ContractEuro IndexJapanese Yen
30.0%25.0%20.0%15.0%10.0%5.0%0.0%-5.0%-10.0%-15.0%-20.0%-25.0%© StockCharts.com 2003
Apr Jul Oct
FIGURE 11.13
Apr Jul Oct
Apr Jul Oct
Apr Jul Oct
-30.0%
Apr
Gold has risen faster than both foreign currencies since 2000.
applied directly to the ratio lines themselves (as well as other technical indicators like moving averages). A rising bond/stock ratio favors investment inbonds over stocks. A falling bond/stock ratio favors stocks over bonds. Arising bond/stock ratio is usually associated with economic weakness, whilea falling bond/stock ratio is associated with economic strength. A rising CRB/bond ratio (or a rising CRB/stock ratio) ratio favors investments in commodity markets over bonds and/or stocks.The commodities included in the CRB Index should qualify as an assetclass along with bonds and stocks. Because commodity markets are usuallynegatively correlated to bonds, and show little correlation to stocks, an unleveraged commodity portfolio (with 10 percent in commodity futures and90 percent in Treasury Bills) could be used to diversify a portfolio of bondsand stocks. The risks usually associated with commodity trading are theresult of low margin requirements and resulting high leverage. By using aconservative (unleveraged) approach of keeping the unused 90 percent of thefutures funds in Treasury bills, much of the risk associated with commoditytrading is reduced and its use by portfolio managers becomes more realistic.Futures markets—including commodities, currencies, bonds, and stockindex futures—provide a built-in model for asset allocation. Because their
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returns are poorly correlated with bond and stock market returns, professionally managed futures funds may qualify as a legitimate diversificationinstrument for portfolio managers. There are two separate approachesinvolved in the potential use of futures markets for diversification. One has todo with the use of professionally managed futures accounts, which invest inall four sectors of the futures markets (and also operate from both the longand the short side of those markets). In this way, the futures portfolio istreated as a separate entity. The term futures refers to all futures markets, ofwhich commodities are only one portion. The second approach treats thecommodity portion of the futures markets as a separate asset class and utilizes a basket approach to trading these commodities.When commodity prices are rising, the U.S. dollar is usually falling. Foreign currency markets usually rise along with commodity markets. A casecan be made for also including currencies as a separate asset class along withcommodities. The impact of currency trends on global bond and stockreturns should also be taken into consideration by global investors. Currencyhedging can help alleviate some of the risks associated with investing in foreign markets. One of the side effects of a falling dollar is a rising gold market.A truly global bull market in gold, however, requires that bullion rise in valuenot just in dollar terms, but in foreign currency terms as well. Since the second half of 1999, when gold bottomed, the price of bullion has outpaced gainsin all major foreign currencies. This has not happened since the 1970s, whichwas the last time that gold embarked on a major bull market.
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C H A P T E R 12
Intermarket Analysisand theBusiness Cycle
THE FOUR-YEAR BUSINESS CYCLEOver the past two centuries, the American economy has gone through repeatedup and down cycles. Sometimes these cycles have been dramatic, such as theGreat Depression of the 1930s, the runaway inflationary spiral of the 1970s,and the deflation-inspired downturn since 2000. At other times, their impacthas been so muted that their occurrence has gone virtually unnoticed. Mostof these cycles fit somewhere in between these two extremes and have left atrail of fairly reliable business cycle patterns that have averaged about fouryears in length. This means that approximately every four years the economyhas experienced a period of expansion, which is followed by a contraction orslowdown. Those slowdowns usually coincide with or follow downturns inthe stock market. The tendency for the stock market to hit bottom every fouryears is referred to as the presidential cycle because American presidentsare elected every four years.The contraction phase often turns into a recession, which is a period ofnegative growth in the economy. The recession or slowdown inevitably leadsto the next period of expansion. During an unusually long economic expansion, when no recession takes place, the economy may undergo a slowdownwhich allows the economy to “catch its breath” before continuing to its nextgrowth phase. When this happens, the time between actual recessions canstretch out to eight years. The recessions of 1970 and 1974 were exactly fouryears apart. The next scheduled recession during 1978 did not occur onschedule. However, two recessions occurred in 1980 and 1982. Even thoughthe 1980 recession was two years late, the 1982 recession occurred “on time”:eight years after the 1974 recession.179
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Following the 1982 recession, it took eight years for the 1990 recession toarrive. After 1990, the U.S. economy entered the longest expansion on record(lasting just over 10 years), which exceeded the previous record expansion ofthe 1960s. When no recessions actually occur, the timing of stock marketdownturns is helpful since bear markets are usually associated with expectations for economic weakness. Based on the four-year business cycle, forexample, the economy skipped scheduled recessions in 1986 and again in1994. However, major downturns in the stock market occurred during 1987and 1994, still adhering quite closely to the business cycle model.Since 1948, the American economy has experienced nine recessions.Prior to 1990, when the last economic expansion started, postwar expansions averaged 45 months in length, while economic contractions averaged11 months. By 2000, 10 years had elapsed since the last recession and sixyears since the last bear market in stocks. A recession and a bear marketwere long overdue. The bear market started during the spring of 2000.A recession started a year later during the spring of 2001.
THE BUSINESS CYCLE EXPLAINS INTERMARKET ROTATIONThe business cycle has an important bearing on the financial markets. Theseperiods of expansion and contraction provide an economic frameworkthat helps explain the linkages that exist between the bond, stock, and commodity markets. In addition, the business cycle explains the chronologicalsequence that develops among these three financial markets. Near the end ofan economic expansion, bonds usually turn down before stocks and commodities. During a recession or slowdown, bonds usually turn up beforestocks and commodities. In both instances, commodities are usually the lastmarket to change direction. A better understanding of the business cyclesheds light on the intermarket process and confirms that what is seen on theprice charts makes sense from an economic perspective. At the same time,intermarket analysis can be used to help determine the current state of thebusiness cycle. Although it is not our primary intention as investors, intermarket analysis can have a role in economic forecasting.Some understanding of the business cycle (together with intermarketanalysis of bonds, stocks, and commodities) impacts on the asset allocationprocess. Different phases of the business cycle favor different asset classes.The beginning of an economic expansion favors financial assets (bonds andstocks), while the latter part of an expansion favors commodities (or infla-
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tion hedges like gold and oil stocks). As a general rule, periods of economicstrength favor stocks, while periods of weakness favor bonds.In this chapter, the business cycle is used to help explain the chronological rotation that normally takes place between bonds, stocks, and commodities. Most of the commodity research presented in this chapter is basedon the Journal of Commerce Index, which is comprised of industrial commodity prices. This is different from the CRB Index in that it does not includeagricultural markets. This book presents research on the predictive ability ofbonds, stocks, and commodities in anticipating turns in the economy. Thethreat of deflation has resurfaced for the first time since the 1930s; it is beneficial to look at the intermarket relationships that existed during that era.
THE CHRONOLOGICAL SEQUENCEOF BONDS, STOCKS, AND COMMODITIESFigure 12.1 (taken from “InterMarket Review” written by Martin J. Pring)shows an idealized diagram of how the three financial markets interact witheach other during a typical business cycle. The curving line shows the path ofthe economy during alternating periods of expansion and contraction. Arising line indicates expansion and a falling line, contraction. The horizontalline is the equilibrium level that separates positive and negative economicgrowth. When the curving line is above the horizontal line but declining, the
FIGURE 12.1
An idealized diagram of how bonds (B), stocks (S),and commodities (C) interact during a typicalbusiness cycle. (InterMarket Review by Martin J.Pring, www.pring.com.)
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economy is slowing. When it dips below the horizontal line, the economy hasslipped into recession. The arrows show the direction of the three financialmarkets—B for bonds, S for stocks, and C for commodities.The diagram shows that as the expansion matures, bonds are the first ofthe three markets to turn down. This is due to increased inflation pressures(arising from rising commodity prices) and resulting upward pressure oninterest rates. In time, higher interest rates put downward pressure on stocks,which turn down second. Because inflation pressures are strongest near theend of the expansion, commodities are the last of the three to turn down.Usually by this time, the economy has started to slow and is slipping intorecession. A slowdown in the economy reduces demand for commodities.Inflation pressures begin to ease. Commodity prices start to drop. At thispoint, all three markets are dropping.As the economy starts to weaken, interest rates begin to soften as well(usually in the early stages of a recession). As a result, bond prices begin torally. For a time, bond prices rise while stock prices fall. After some time,stocks begin to turn up as well (usually after the midpoint of a recession).Only after bonds and stocks have been rallying for a time and the economyhas started to expand will inflation pressures start to build, contributing to anupturn in gold and other commodities. (As already discussed, the upturn incommodities may also occur in a deflationary climate as the Fed tries toreflate a sagging economy.) After an economic expansion has been in placefor some time, there can come a point where all three markets are risingtogether. This can continue until the inflationary impact of rising commodityprices causes bond prices to peak. At this point, bonds turn down and thewhole process starts over again.
BONDS ARE THE FOCAL POINTBonds seem to be the focal point in the intermarket chain. Bonds are usuallythe first market to peak and the first to bottom. When bond prices are muchweaker than stocks, it tells us that inflationary pressures are building, whichcan eventually hurt stocks. An unusually strong bond market relative tostocks (such as existed after 2000) can send the opposite signal, namely thatdeflationary forces are present, which may also hurt stocks. Bonds have atendency to peak about midway through an economic expansion and hit bottom about midway through a contraction. The peak in bond prices during aneconomic expansion is a signal that a period of healthy noninflationary
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growth has turned into an unhealthy period of inflationary growth. This isusually the point where commodity markets are starting to accelerate on theupside and the bull market in stocks is living on borrowed time. In the unusualsituation in which deflation is a threat, rising commodity prices and a weakerbond market may indicate that deflationary forces are abating and may be apositive sign for the stock market and the economy.
THE SIX STAGES OF THE BUSINESS CYCLEMartin Pring divides the business cycle into six stages (see Figure 12.2).Stage 1 begins as the economy is slipping into a recession and ends withStage 6, where the economic expansion has just about run its course. Eachstage is characterized by a turn in one of the three asset classes—bonds,stocks, or commodities. The following list summarizes Pring’s conclusions:Stage 1 . . . Bonds turn upStage 2 . . . Stocks turn upStage 3 . . . Commodities turn upStage 4 . . . Bonds turn downStage 5 . . . Stocks turn downStage 6 . . . Commodities turn down
FIGURE 12.2
(stocks and commodities falling)(bonds rising, commodities falling)(all three markets rising)(stocks and commodities rising)(bonds dropping, commodities rising)(all three markets dropping)
The six stages of a typical business cycle throughrecession and recovery. Each stage is characterized bya turn in one of the three sectors—bonds, stocks, andcommodities. (InterMarket Review by Martin J. Pring,www.pring.com.)
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The implications of the above sequence for asset allocators should befairly obvious. As inflation and interest rates begin to drop during a slowdown (Stage 1), bonds (or interest-sensitive stocks) are the place to be. Afterbonds have bottomed and as the recession shows some signs of leveling off(Stage 2), stocks become attractive. As the economy begins to expand again(Stage 3), gold and gold-related assets should be considered as an early inflation hedge. As inflation pressures begin to pull other commodity priceshigher, and interest rates begin to rise (Stage 4), commodities or other inflation hedges should be emphasized. Bonds and interest-sensitive stocksshould be de-emphasized. As stocks begin a topping process (Stage 5), moreassets should be funneled into commodities and other inflation hedges suchas gold and oil shares. When all three asset groups are falling (Stage 6), “cashis king,” as the saying goes.The chronological sequence described in the preceding paragraphs doesnot imply that bonds, stocks, and commodities always follow this exact rotational sequence. There have been times when the markets have peaked andtroughed out of sequence. Pring’s diagram describes the ideal rotationalsequence that usually takes place between the three markets; it gives us auseful roadmap to follow. When the markets are following the ideal pattern,the analyst knows what to expect next. When the markets are diverging fromthe normal rotation, the analyst is alerted to the fact that something is amissand is warned to be more careful. While the intermarket analyst may notalways understand exactly what the markets are doing, it can be helpful toknow what they are supposed to be doing. The lessons of the markets since2000 are an excellent example of why it is a good idea to be especially vigilant when something unusual is happening.
LESSONS OF 2000After the stock market bubble burst in 2000, the Federal Reserve embarkedon an aggressive series of interest rate cuts that should have stemmedthe stock market’s decline. By the end of 2001, the Fed had lowered rates11 times. However, the usual beneficial impact of falling rates was nothelping stocks. Bonds and stocks had completely decoupled. Somethingunusual was happening in this business cycle. As already stated, the unusual ingredient was the threat of global deflation, something that had notbeen experienced since the 1930s. The fact that none of the current generation of investors (or economists) had lived through the earlier deflation-
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ary cycle probably explains why so few of them recognized its dangeroussymptoms.
BONDS AS A LEADING ECONOMIC INDICATORBond prices have an impressive record as a leading indicator of the economy,although the lead time at peaks and troughs can be quite long. In LeadingIndicators for the 1990s (Don Jones-Irwin, 1990), Geoffrey Moore (one of thenation’s leading authorities on the business cycle) details the history of bondsas a long-leading indicator of business cycle peaks and troughs. By 1990, whenDr. Moore published his research, the U.S. economy had experienced eightbusiness cycles starting in 1948. The Dow Jones 20 Bond Average led each ofthe business cycle peaks by an average of 27 months. At the eight businesscycle troughs, the bond lead was seven months on average. From 1948 through1990, bond prices led all business cycle turns by an average of 17 months.
STOCKS AND COMMODITIES AS LEADING INDICATORSStocks and commodities also qualify as leading indicators of the businesscycle, although their warnings are much shorter than those of bonds. Research provided by Dr. Moore (in collaboration with Victor Zarnowitz andJohn P. Cullity) in the previously-cited work, Leading Indicators for the1990s, provides us with lead and lag times for all three markets—bonds,stocks, and commodities—relative to turns in the business cycle. This supports the rotational process described in Figure 12.1.In the eight business cycles from 1948 to 1990, the S&P 500 stock indexled turns in the business cycle by an average of seven months, with a ninemonth lead at peaks and a five-month lead at troughs. Commodity prices(represented by the Journal of Commerce Index) led business cycle turns byan average of six months, with an eight-month lead at peaks and a two-monthlead at troughs.Several conclusions can be drawn from these numbers. One is that technical analysis of bonds, stocks, and commodities can play a role in economic analysis. Technical analysis can be applied to all three markets.Another is that the rotational nature of the three markets (as pictured inFigure 12.1) is confirmed. Bonds turn first (17 months in advance), stocks
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second (seven months in advance) and commodities third (six months inadvance). The rotational sequence of bonds, stocks, and commodities turning in the proper order is maintained at both peaks and troughs. In all threemarkets, the lead at peaks is much longer than at troughs. The lead timegiven at peaks by bonds can be extremely long (27 months on average) whilecommodities provide a very short warnings at troughs (two months on average). The lead time for commodities may vary depending on the commodityindex being used. Dr. Moore uses the Journal of Commerce Index, which hehelped create; it is an index comprised of industrial commodities. MartinPring also expresses a preference for using industrial commodities. Theirwork places less importance on agricultural commodities, which are included in the CRB Index.
MORE ON THE JOC INDEXThe Journal of Commerce Index was introduced in Chapter 3. Its full nameis the Journal of Commerce (JOC)—Economic Cycle Research Institute(ECRI) Industrial Price Index. The JOC Index is made up of 18 industrialcommodity prices which include textiles, metals, petroleum products, andsome miscellaneous prices that include plywood. The metals categoryincludes aluminum, copper, lead, nickel, tin, steel, and zinc. Dr. Moore’s pioneering work on the impact of the financial markets on the business cycle iscarried on by the Economic Cycle Research Institute, currently located inNew York City. Let us follow the intermarket script laid down by Dr. Moorein 1990 to see if the bond, stock, and commodity markets correctly anticipated the recession that started in the spring of 2001.
PREDICTING THE 2001 RECESSIONFor this study, I refer to an article that I wrote for the MurphyMorris.comwebsite on January 8, 2001 entitled “Market Suggests Recession Due.” Thestock market had peaked during the previous spring and commodity priceshad started to fall. The intention of the this article was to try to use the financial markets to time the onset of a possible recession. To do this, I relied onthe numbers published by Dr. Moore for bonds, stocks, and commodities.Here is what I wrote:
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Bonds usually peak an average of 27 months before the economy. Treasury bond prices peaked in October of 1998. Counting forward fromthat month suggests that a recession would be due to start in January2001 (this month). . . . The S&P 500 usually peaks about nine monthsbefore a recession. The S&P 500 peaked in March 2000—giving a possible target for the onset of a recession in December of 2000 (which waslast month). . . . The Journal of Commerce Index (which is the commodity benchmark used in Dr. Moore’s research) peaks an average ofeight months before the economy. It hit two peaks last year—March andSeptember. That projects a possible recession anywhere from November2000 to July 2001.Although the economy had already started to weaken when this articlewas written at the start of 2001, the recession did not officially start until twomonths later in March 2001 (determined by the National Bureau of EconomicResearch). The three financial markets still did a credible job not only ofpredicting the start of the 2001 recession, but also in following Dr. Moore’spublished timetable. If we use the Fed’s actions as an indication of when theeconomy started its contraction, the recession date would be in January 2001when they lowered rates for the first time.
THE THREE MARKETS FOLLOWEDTHE PROPER ROTATION FOR TOPSThere are two lessons to be learned in studying this time period. One is simply the fact that the financial markets do lead turns in the economy—andthese turns can be timed with some degree of accuracy. The second is thefact that all three markets turned in the proper rotational order. Bonds peakedfirst during October 1998, the S&P 500 peaked second during March 2000,and commodities peaked third. The commodity peak shows some variationdepending on which commodity index is used. The JOC Index showed twopeaks—one in March 2000 and a second one in September 2000. If the first(March) peak is used, it would mean that stocks and commodities peakedtogether. (There is some precedent for this as we will see shortly when discussing the 1920s.) If the second (September) peak is used, commoditiespeaked six months after stocks. The CRB Index (which includes agriculturalmarkets) peaked in October 2000—seven months after the S&P 500 did (seeFigures 12.3 through 12.5).
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30-Year US Treasury Bond Price
116.0114.0112.0110.0108.0106.0104.0102.0100.098.096.094.092.090.088.0© StockCharts.com 2003
Apr Jul Oct
FIGURE 12.3
Apr Jul Oct
Apr Jul Oct
Apr Jul Oct
Bond prices peaked in October 1998, which projected a recessionwithin 27 months.
CRB Index
© StockCharts.com 2003
Jul
Oct
FIGURE 12.4
86.0
Apr
Apr
Jul
Oct
Apr
Jul
Oct
Apr
The CRB peaked in October 2000 six months after stocks and two yearsafter bonds.
235.0232.5230.0227.5225.0222.5220.0217.5215.0212.5210.0207.5205.0202.5200.0197.5195.0192.5190.0187.5185.0182.5
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1600.0
S&P 500 Large Cap Index
1550.01500.01450.01400.01350.01300.01250.01200.01150.01100.01050.01000.0950.0© StockCharts.com 2003
Jul
Oct
FIGURE 12.5
Apr
Jul
Oct
Apr
Jul
Oct
900.0