Several intermarket changeswere very dramatic after 2000.• Basic intermarket principles䡩 All markets are linked, domestically and globally䡩 No market moves in isolation䡩 Analysis of one market should include all the others• Market Groups䡩 The four market groups are stocks, bonds, commodities, and currencies• Market Relationships䡩 The dollar and commodities trend in opposite directions (Figure 6.6)䡩 Bond prices and commodities trend in opposite directions (Figure 6.7)䡩 Bonds and stocks normally trend in the same direction (Figure 6.8)260.0255.0
US Dollar IndexCRB Index
© StockCharts.com 2003
105.0
250.0
102.5
245.0
100.0
240.0235.0
97.5
230.0
95.0
225.0
92.5
220.0215.0
90.0
210.0
87.5
205.0200.0
85.0
195.0
82.5
190.0
80.0
185.01993
FIGURE 6.6
1994
1995
1996
1997
1998
The dollar and commodities trend in opposite directions.
1999
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115.0
INTERMARKET ANALYSIS
CRB Index30-Year US Treasury Bond Price
© StockCharts.com 2003
340.0
110.0105.0
320.0
100.0300.0
95.090.0
280.0
85.080.0
260.0
75.070.0
240.0
65.0220.0
60.055.0
200.0
50.045.080 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99
FIGURE 6.7
110.0105.0100.0
Bond prices and commodities trend in opposite directions.
1400.01300.01200.01100.01000.0900.0800.0700.0
S&P 500 Large Cap Index30-Year US Treasury Bond Price
95.090.085.0
600.0
80.0
500.0
75.0
400.0
70.0
300.0
65.060.0
200.055.050.0© StockCharts.com 2003
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99
FIGURE 6.8
Bonds and stocks normally trend in the same direction.
100.0
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Review of Intermarket Principles
䡩䡩䡩䡩
95
Bonds peak and trough ahead of stocksDuring deflation, bond prices rise while stocks fallA rising dollar is good for U.S. bonds and stocksA weak dollar favors large multinational stocks
• Effects of commodity/bond ratio䡩 A rising commodity/bond ratio favors inflation-type stocks includinggold, energy, and basic material stocks like aluminum, copper, paperand forest products䡩 A falling commodity/bond ratio favors interest rate-sensitive stocksincluding consumer staples, drugs, financials and utilities
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CHAPTER 7
The NasdaqBubble Burstsin 2000
AN HISTORIC YEARThe preceding chapter discussed how 1999 experienced a rising inflationthreat from rising oil and industrial material prices. This pushed interest rateshigher, which began to have a negative impact on those sectors of the stockmarket that tend to be “early peakers.” Interest rate-sensitive stocks are anexample. Old economy stocks, which are sensitive to interest rate direction,had already started to weaken (which was reflected mainly in a falling NYSEAdvance–Decline line). By contrast, new economy stocks shrugged off thethreat of rising rates during the second half of 1999. Something happened atthe start of year 2000, however, as a direct result of the dangerous intermarket trends that existed the previous year. The Fed had started raising shortterm interest rates during the middle of 1999. By the first quarter of 2000, thistightening by the Fed had led to a condition known as an inverted yield curve.
INVERTED YIELD CURVE IMPLIES ECONOMIC WEAKNESSAn inverted yield curve, like the one that occurred near the start of 2000, is thegraphical depiction of short-term interest rates that have risen above longterm rates. This usually occurs after a round of Fed tightening and, in thepast, has been an early warning of economic weakness. The recessions of1990, 1982, 1980, 1974, and 1970 were all preceded by inverted yield curves. Ina normal yield curve, long-term rates are higher than short-term rates. Whenthe Fed tightens monetary policy to fight off an inflation threat, it raises short97
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term rates. The danger point for the economy (and the stock market) occurswhen the Fed pushes short-term rates over long-term rates. This point wasreached at the start of 2000. When an inverted yield curve develops, the stocksthat become most vulnerable are those with the highest price/earnings ratios.At the start of the new millennium, those overvalued stocks happened to be inthe dot-com world of Internet and technology stocks that resided in the Nasdaq market. By that spring, the bubble had finally burst in the Nasdaq market,and the longest bull market in history had become history. While this proveddisastrous for the Nasdaq market, it actually launched bull runs in defensivemarket sectors that do better in the early stages of an economic slowdownlike consumer staples, financials, utilities, and REITs. All of the intermarkettrends—the good ones and the bad ones—were clearly visible on marketcharts as 2000 started. These trends gave ample warning that not only thestock market was in trouble—the entire economy was as well.
THE WARNING SIGNS WERE THERE ON THE CHARTSLet us study the year 2000 in some depth. It was such an historic year andthere were so many intermarket lessons to be learned. Another reason tostudy that year so closely was that it demonstrated the danger in relying tooheavily on economic and fundamental analysis, to the exclusion of pricecharts and technical market analysis. One of the basic premises of technicalwork is that the markets are leading indicators of economic and fundamentaltrends. This means that the stock market usually peaks six to nine monthsahead of the economy. Those who ignored the bearish technical signs on thestock market charts paid a heavy price—or at least their clients did. Some ofthese bearish signs came from traditional technical indicators like a fallingNYSE Advance–Decline line and the breaking of chart support levels by themajor stock indexes. Earlier warnings had come from dangerous intermarkettrends that started the year before. Warnings came from sector rotations outof late expansion stocks into early contraction stocks. Another warning camefrom classic economic indicators like the inverted yield curve. The Wall Streetcommunity either missed the classic warning signs or chose to ignore them.
SEEING THINGS AS THEY HAPPENOne of the traps that a financial writer can fall into is to analyze history withthe benefit of hindsight. It is always a temptation to go into the past to
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choose the right chart to prove one’s point or to reinterpret events after thefact. The best way to avoid this is to show charts that were visible at the timethe historic market turns were taking place, and then quote from marketanalysis made at that time with these same charts. That is what is done inthis chapter. Most of the charts shown in this chapter are taken from marketmessages published on the MurphyMorris.com website on January 30, 2000along with the commentary that accompanied them. In some cases, the verbatim quote is given and, in others, the commentary is paraphrased. Themain reason for doing it in such a way is to show that the intermarket principles explained throughout this book, combined with traditional technicalanalysis, were seen while they were happening—not just with the benefit ofhindsight. This chapter also describes how market events of 2000 “bridgedthe gap” between technical market analysis and economic analysis. The nexttwo paragraphs are taken from a market message published at the end ofJanuary 2000.
JANUARY 30, 2000: YIELD CURVE INVERSIONThere was a lot of talk in the media this week about the inversion of theyield curve. They kept describing the market action as confusing. Wedon’t agree. Here’s how it works. In the late stages of an economicexpansion, early signs of inflation begin to crop up—usually in theform of rising commodity prices. That puts upward pressure on bondyields. At some point, the Fed starts to raise interest rates to slow downthe economy. That causes short-term rates to rise faster than long-termrates. The danger point arrives when short-term rates move above longterm rates (which happened this past week) . . . While an inverted yieldcurve helps bonds, it’s negative for stocks.Figure 7.1 shows the yield curve as it appeared on January 28, 2000. Thedownward slope meant that short-term rates were higher than long-term rates.
1969 ALL OVER AGAIN?In the past, inverted yield curves have usually marked the end of economic expansions and the end of bull markets in stocks. The currenteconomic expansion is now in its 106th month—which matches theprevious record that lasted from 1961 to 1969. An inverted yield curveduring 1969 signaled the end of that record expansion and the onset of
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CurrentPrevious
%6.66.46.26.05.85.65.4
3M 1Y 2Y
5Y
10Y
30Y0.00-0.05-0.10
3M 1Y 2Y
FIGURE 7.1
5Y
10Y
30Y
An inverted yield curve existed on January 28, 2000.
a recession the following year (1970). 1969 also marked the highpointfor the Dow (1000) which wasn’t exceeded for another thirteen years(until 1982).
JANUARY LOWS BROKENDuring the second half of January, the Dow and the S&P 500 broke theirJanuary lows. They also fell beneath their 200-day moving averages, which isusually a serious warning of a major market decline. Figure 7.2 (which wasposted on January 20, 2000) shows the Dow falling under chart support andits 200-day moving average. At the same time, the NYSE Advance–Declineline fell to the lowest levels in three years. The so-called January Barometerwas on the verge of giving a negative signal for the year. (The January Barometer is based on the idea that as January goes, so goes the rest of the year.)As was noted at the time, January 2000 was not just a bad January. It was theworst January for the Nasdaq since 1990 and the worst for the S&P 500 in 30
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Dow Jones Industrial AverageMoving Average (200 days)
11800.011600.011400.011200.011000.010800.010600.010400.010200.0© StockCharts.com 2003
Aug
FIGURE 7.2
Sep
Oct
Nov
Dec
10000.0
Feb
The Dow Industrials fell under chart support and the 200-day average in 2000.
years. The negative implications of all of these technical intermarket warnings—not to mention the inverted yield curve—seemed pretty clear at thetime. As a result, the January 30 website update ended with the followingparagraph.
CASH IS GOODIf the inverted yield curve is truly signaling economic weakness laterthis year, that will probably have a negative impact on stocks. As theFed raises short-term rates, the primary beneficiaries are usuallymoney market funds, which get higher yields as a result. Recent developments suggest . . . that it’s time to take a much more defensive posture in the stock market which favors bonds, consumer staples, drugs,financials, and utilities. The best place to be, however, is probably amoney market fund. We think it’s time to take some money out of thestock market and raise your cash levels.
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APRIL 15, 2000: NASDAQ BREAKSMOVING AVERAGE LINE–NYSE FAILUREBy mid-April 2000, the Nasdaq had suffered its first Friday close beneath its40-week (or 200-day) moving average since August of 1998. It had alreadylost 34 percent from its peak, which exceeded its 1998 drop of 30 percent.These are the types of numbers that worry chartists who see ominous warnings in drops of that sort. Meanwhile, the NYSE Composite Index had beenin a trading range since the previous July when the Fed started tightening.The NYSE had failed a “retest” of that old high and had fallen under its 200day moving average. With all major stock averages beneath their 200-daymoving averages, the risk level in the entire market had taken a turn for theworse. Figure 7.3 (which was posted on April 15, 2000) shows the NYSE failing a test of the highs that had been hit the previous summer; it also showsthe NYSE falling below its 200-day moving average. The caption on thechart describes the situation as “at best, still a trading range. . . . At worst,a possible top.”
NYSE Composite IndexMoving Average (200 days)
7000.0
NYSE INDEX FAILS TEST AT TOP OF RANGE.AT BEST, STILL A TRADING RANGE; AT WORST,A POSSIBLE TOP.
6900.06800.06700.06600.06500.06400.06300.06200.0
SUPPORT
6100.0
© StockCharts.com 2003
Feb Mar
FIGURE 7.3
Apr May Jun
Jul Aug Sep Oct Nov Dec
Feb Mar
Apr
The NYSE failed a test of the highs hit during the summer of 1999.
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REITS HOLD UPReal estate funds (or REITs) were the top-performing stock group during thefirst half of April (as the Nasdaq was tumbling). Investors often turn to realestate funds for possible bear market insurance. REITs have three thingsgoing for them. The first is that there are high dividend yields (often in excessof 7 percent), which have more appeal in a falling stock market. Second,REITs show a low correlation with the stock market. As a result, they providediversification value when the market is in trouble. Third, REITs historicallyhave a negative correlation to technology stocks. As such, they usually risewhen the techs fall. This is exactly what they did during the spring of 2000.
REITS SHOW GOOD RELATIVE STRENGTHA relative strength ratio of the Morgan Stanley REIT Index (RMS) divided bythe S&P 500 turned up during April (just as the Nasdaq was peaking), asshown in Figure 7.4. The relative strength line rose to a six-month high that
REITs / S&P 500 RatioMoving Average (200 days)
0.2550.2500.2450.2400.2350.2300.2250.2200.2150.2100.2050.2000.1950.190
© StockCharts.com 2003
May
Jun
FIGURE 7.4
Jul
Aug
Sep
Oct
Nov
Dec
Feb
Mar
Apr
The REIT/S&P ratio turned up in April 2000 as the Nasdaq was peaking.
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month and also broke a yearlong down trendline. In addition, the ratio lineexceeded its 200-day average for the first time in two years. In addition to rising relative performance, REIT prices were rising as well.
REIT INDEX TURNS UPREITs fell into a bear trend that began at the start of 1998 and ended duringthe fourth quarter of the same year. Near the end of 1999—a little over ayear later—they “retested” their 1998 lows and started to bounce. DuringApril 2000, the REIT Index broke its two-year down trendline. It alsoachieved a bullish breakout by exceeding its January high. Real estatemutual funds turned up as well. Figure 7.5 shows the Cohen & Steers RealtyFund turning up during March and breaking a down trendline during April.(A real estate mutual fund is the easiest way for an individual investor toparticipate in a REIT sector rally. Mutual funds can be charted just likeanything else.)
Cohen & Steers Realty Shares, Inc.Moving Average (200 days)
39.038.538.0TWO-YEAR DOWN TRENDLINE
37.537.036.536.035.535.034.534.033.533.032.532.0
© StockCharts.com 2003
Mar
Apr
May
FIGURE 7.5
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Feb
Mar
Example of a REIT mutual fund turning up in the spring of 2000.
Apr
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APRIL 21, 2000: MARKET’S ECONOMIC MESSAGE—ECONOMIC SLOWINGIntermarket work bridges the gap between traditional technical market analysis and economic trends. Although it may seem strange to have a technicalanalyst use the preceding headline, this is exactly what happened on April 21,2000. Although economic analysis is not our primary goal, the markets oftentell us a lot about the future course of the economy. The April 21 market comment that year was devoted to a discussion of what the markets were tellingus about the economy.From a more practical side, the market’s message about the direction ofthe economy also gave clues as to what sectors of the market should startto do better given the likely position in the economic cycle. These economicconclusions also influence asset allocation decisions. Bonds usually do better than stocks during an economic contraction. This is exactly what happened in 2000 and for several years thereafter. When bonds are strong,rate-sensitive stock sectors do better. This also happened in 2000. The nextfour paragraphs are based on the April 2000 message.
COPPER AND LONG RATES PEAK TOGETHERAT START OF 2000Certain key commodities help gauge the strength of the economy (and thedirection of interest rates). The previous year saw a rise in industrial commodity prices and the upward pressure they put on interest rates. This picturereversed by the spring of 2000. Copper, which had been rising throughout1999, peaked in January of 2000 and fell beneath its 200-day moving averageduring April. Figure 7.6 (posted on April 21, 2000) shows copper breaking anup trendline during February 2000 and, more importantly, its 200-day movingaverage during April. Since copper is a barometer of economic strength, itsfall at the start of 2000 was a warning sign that the economy was weakening.At the same time that copper was peaking, the yield on the 10-year T-notestarted dropping as well. Figure 7.7 shows the 10-year T-note yield peaking inJanuary 2000 and breaking its 200-day average during April. At the time, thesetwo factors were interpreted as early signs that the inverted yield curve thathad occurred in January was indeed starting to slow the economy. Evidenceof this was also seen in how the various stock market sectors were behaving.
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90.0
Copper Futures - COMEXMoving Average (200 days)
87.585.082.580.077.575.072.5COPPER PRICES HAVE PEAKED70.067.565.0© StockCharts.com 2003
Jun
Jul
FIGURE 7.6
Aug
Sep
Oct
Nov
Dec
Feb
Mar
62.5
Apr
Copper broke a support line and its 200-day average during April 2000.
10-Year T-Note YieldMoving Average (200 days)
68.066.064.062.060.058.0PEAKS IN YIELDSALSO HINT ATECONOMIC SLOWING
56.054.052.0
© StockCharts.com 2003
Apr
May
FIGURE 7.7
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Feb
The 10-Year T-Note yield peaked during January 2000.
Mar
Apr
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ECONOMIC WEAKNESS FAVORS CONSUMER STAPLESCertain market sectors do better at different stages in the economic cycle. Inthe early contraction phase, the best-performing sector is consumer staples.Once the contraction takes hold, other groups like utilities and financials startto do better. The April 21, 2000, website message contained the following conclusion: “Our reading of the market suggests we’re somewhere in between the‘late expansion’ and ‘early contraction’ phase of the economic cycle.”
CONSUMER STAPLES START TO OUTPERFORMA relative strength ratio of the Morgan Stanley Consumer Index divided bythe Dow (posted in April 2000) showed consumer stocks starting to outperform the Dow for the first time in a long time (see Figure 7.8). Consumerstaples are defensive in nature, and include industry groups like beverage,food, drug, tobacco, and household products. The reasoning is that people
Consumer / DJIA Ratio
0.05100.05000.0490CONSUMER STOCKSSTARTING TO DO BETTER
0.04800.04700.04600.04500.0440
© StockCharts.com 2003
Oct
FIGURE 7.8
Nov
Dec
Feb
Mar
The Consumer/Dow ratio turned up during April 2000.
Apr
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still have to use these products in good times and bad. Relative strength inthis group often hints at economic slowing. The April 21 commentary endedwith the following paragraph.
THINGS COULD NOT BE BETTERWall Street economists keep telling us things couldn’t be better. If thingscan’t get any better, doesn’t that mean they can only get worse? Historically, the markets usually turn down long before the economy does.That’s why the markets are considered to be leading indicators of theeconomy. And the market’s message is that the economy is starting toslow. In time, that will hurt corporate earnings and the stock market.At such times, it’s usually better to be in defensive sectors of the market (including money market funds). Last week, we commented on theupturn in REITs—a traditional defensive haven. Consumer staplesalso look like a good defensive choice.
AUGUST 11, 2000: SHIFT TO VALUEThe collapse in the Nasdaq market in the spring of 2000 caused several rotations to take place within the stock market that year. As previouslydescribed, there was a rotation out of technology and into consumer staplesand REITs. Bonds also turned up as stocks in general started to weaken.Another major shift that took place that year was a move out of growthstocks into value stocks. This trend was described in a market message published on August 11, 2000. The first paragraph ended with the followingobservation: “Leadership in the market appears to have shifted back to oldeconomy stocks (represented by the Dow) and away from the new economystocks (represented by the Nasdaq).” The following paragraph was includedin that same market message.Another sign that investors are bracing for a weaker economy during2000 is the shift back to value . . . For the past three years, value hasunderperformed growth. However, the S&P Value/Growth ratio formedtwo bottoms (in March and July) and is trending higher, as shown inFigure 7.9. Value stocks (with low price/earning ratios) usually do better than growth stocks (with high p/e ratios) in a weakening economy.
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Value Index / Growth Index RatioMoving Average (200 days)
0.820.80FOR THE FIRST TIME IN TWOYEARS, VALUE IS STARTING TOOUTPERFORM GROWTH
0.780.760.740.720.700.680.66
DOUBLE BOTTOM
© StockCharts.com 2003
Sep
Oct
FIGURE 7.9
Nov
Dec
Feb
Mar
Apr
May
Jun
0.64Jul
Aug
Value stocks started outperforming growth stocks during 2000.
It just so happens that most of the value stocks reside in the old economy, while most of the growth stocks are in the Nasdaq.This switch from growth to value continued into the spring of the following year. However, it was just another manifestation of the same message—economic slowing and a faltering stock market. As suggested earlier,different sectors outperform at various stages in the economic cycle. It istime to show you where that information comes from.
SECTOR ROTATION WITHIN THE ECONOMIC CYCLEFigure 7.10 is a diagram of how market sectors perform at various stages ofthe economic cycle. The diagram was created by Sam Stovall and published inthe Standard & Poor’s Guide to Sector Investing. There are five stages in onecomplete economic cycle—three during an economic expansion and two during an economic contraction. The left side of the diagram shows which sectorsdo best during an economic expansion. “Early Expansion” is characterized by
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EarlyExpansion
MiddleExpansion
LateExpansion
EarlyContraction
LateContraction
• Energy
• BasicMaterials
ConsumerStaples •
• Capital Goods
Utilities •• Services
Financials •• Technology
• Transportation
Consumer Cyclicals •
One Complete Economic Cycle
FIGURE 7.10
How market sectors perform during the business cycle.(Standard & Poor’s Guide to Sector Investing, McGraw Hill,1995.)
relative strength in Transportation and Technology. (One of the reasons thatTransportation stocks lead an economic recovery is due to falling energyprices, a move which occurs during a recession. The diagram also explainswhy leadership in the technology sector is usually a good sign for the economyand the stock market.) “Late Expansion” shows Energy to be the top-performing sector. The next two stages show sector leadership as the economy startsto slow. “Early Contraction” shows Consumer Staples to be the leading marketgroup. “Late Contraction” shows rotation toward Utilities, Financials, and Consumer Cyclicals.In our analysis of 1999 intermarket trends, we stated that Energy leadership (arising from rising oil prices) was a bad sign for the economy. Thereason for this can be seen in the diagram. Energy dominance usually takesplace in the “Late Expansion” phase of the economic cycle and is usually a
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