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IntermarketAnalysisProfiting fromGlobal Market Relationships
JOHN MURPHY
John Wiley & Sons, Inc.
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IntermarketAnalysis
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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.The Wiley Trading series features books by traders who have survivedthe market’s ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader,professional or somewhere in-between, these books will provide the adviceand strategies needed to prosper today and well into the future.
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IntermarketAnalysisProfiting fromGlobal Market Relationships
JOHN MURPHY
John Wiley & Sons, Inc.
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Copyright © 2004 by John Murphy. All rights reserved.Some of the figures in Chapters 1, 2, and 3 were created by Knight Ridder’s Tradecenter.Tradecenter is a registered trademark of Knight Ridder’s Financial Information.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United StatesCopyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center,Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or onthe web at www.copyright.com. Requests to the Publisher for permission should beaddressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street,Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail: permcoordinator@wiley.com.Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties withrespect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. Nowarranty may be created or extended by sales representatives or written sales materials.The advice and strategies contained herein may not be suitable for your situation. Youshould consult with a professional where appropriate. Neither the publisher nor authorshall be liable for any loss of profit or any other commercial damages, including but notlimited to special, incidental, consequential, or other damages.For general information on our other products and services, or technical support, pleasecontact our Customer Care Department within the United States at 800-762-2974, outsidethe United States at 317-572-3993 or fax 317-572-4002.Wiley also publishes its books in a variety of electronic formats. Some content thatappears in print may not be available in electronic books.For more information about Wiley products, visit our web site at www.wiley.com.ISBN: 0-471-02329-9Printed in the United States of America.10 9 8 7 6 5 4 3 2 1
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To Anne, a great poetandto Tim, a great brother
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Contents
Acknowledgments
ix
Introduction to Intermarket Analysis
xi
1. A Review of the 1980s
1
2. 1990 and the First Persian Gulf War
17
3. The Stealth Bear Market of 1994
33
4. The 1997 Asian Currency Crisis and Deflation
51
5. 1999 Intermarket Trends Leading to Market Top
65
6. Review of Intermarket Principles
81
7. The NASDAQ Bubble Bursts in 2000
97
8. Intermarket Picture in Spring 2003
115
9. Falling Dollar During 2002 Boosts Commodities
131
10. Shifting from Paper to Hard Assets
145
11. Futures Markets and Asset Allocation
159
12. Intermarket Analysis and the Business Cycle
179
13. The Impact of the Business Cycle on Market Sectors
199
14. Diversifying with Real Estate
217
15. Thinking Globally
235
Appendix
247
Index
263vii
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Acknowledgments
owe thanks to a lot of people who helped put this book together: Pamelavan Giessen, Executive Editor at Wiley, for talking me into doing it in thefirst place; Jennifer MacDonald and Joanna Pomeranz for making surethat everything wound up in the right place; Heidi Shelton and Pete Behmerat Stockcharts.com for producing great looking charts; John Carder atTopline Investment Graphics for his innovative historical charts; Tim Murphyfor his help with the cover design and computer graphics; those market analysts who generously allowed me to draw from their work including NedDavis, Ken Fisher, Ian Gordon, Martin Pring, and Sam Stovall. And, finally,the McTooles family who kept my spirits up while I was writing this book.
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Introductionto IntermarketAnalysis
n 1990, I completed a book entitled Intermarket Technical Analysis:Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets. My point in writing it was to show how closely related allthe financial markets really are, both domestically and internationally. Thebook’s main thesis was that technical analysts need to broaden their chartfocus to take these intermarket correlations into consideration. Analysis ofthe stock market, for example, without consideration of existing trends in thedollar, bond, and commodity markets was simply incomplete. The book suggested that financial markets can be used as leading indicators of other markets and, at times, confirming indicators of related markets. Because themessage of my earlier text challenged the single market focus of the technical community, some questioned whether this newer approach had any placein the technical field. Many questioned whether intermarket relationshipsexisted at all—and whether they could be used in the forecasting process. Theidea that global markets are linked to each other was also viewed with someskepticism. How things have changed in just one decade.Intermarket analysis is now considered a branch of technical analysis andis becoming increasingly popular. The Journal of Technical Analysis (Summer–Autumn 2002) asked the membership of the Market Technicians Association torate the relative importance of technical disciplines for an academic course ontechnical analysis. Of the fourteen disciplines included in the poll, intermarketanalysis ranked fifth. Intermarket work has come a long way in ten years.
I
EARLIER BOOK COVERED THE 1980sMy earlier text focused on events in the 1980s starting with the end of thecommodity bubble at the start of that decade. This ended the hyperinflation ofxi
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the 1970s when hard assets like commodities soared and paper assets (likebonds and stocks) soured. The 1980 peak in commodities ushered in a twodecade disinflationary trend that coincided with major bull markets in bondsand stocks. The biggest financial event of the 1980s—the 1987 stock marketcrash—provided a textbook example of how markets are related to eachother and the necessity for paying attention to those related markets. A surgein commodity prices—and a collapse in bond prices—during the first half of1987 gave ample warning of an impending stock market decline during thatyear’s second half. Three years later during 1990, as the previous book wasgoing to press, global financial markets were just starting to react to Iraq’sinvasion of Kuwait in August of that year. Gold and oil prices surged—whilestock markets around the world fell. Interestingly, thirteen years later (at thestart of 2003), market observers were facing the prospect of another Iraq warand were studying anew the 1990–1991 market reactions to look for parallels.History has a way of repeating itself, even in intermarket work.
JAPANESE BUBBLE BURSTS IN 1990Another important event which happened at the start of 1990 is still havingglobal repercussions more than a decade later. The bubble in the Japanesestock market burst. This started a thirteen-year descent in that market (whichrepresented the world’s second largest economy) that turned into a deflation (a decline in the prices of goods and services). Over a decade later, western central bankers were studying the Japanese deflation model to find waysto combat increasing signs of deflation in western economies. Some of thecharts presented in this book also bolster the view that Japanese deflationwas one of the major contributing factors to the decoupling of bonds andstocks in the United States years later when rising bond prices starting in2000 coincided with falling stock prices.
THIRD ANNIVERSARY OF 2000 MARKET TOPMarch 10, 2003 marked the third anniversary of the ending of the Nasdaqbubble that signaled the start of the worst bear market in decades. A 50 percent decline in the S&P 500 was the worst since 1974. The Nasdaq’s loss of 78percent was the worst since the stock market crash from 1929–1932 in themidst of the Great Depression. Market historians had to go back to study
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these two periods to gain some insight into market behavior. What madecomparisons between these two earlier periods complicated was that each ofthem was caused by a different economic event. The bear market in stocksduring the 1970s was associated with a period of rising commodity prices—and hyperinflation. The bear market of the 1930s, however, was associatedwith a period of economic deflation. While both situations are bad for stocks,deflation is the more difficult to counter.Starting in 1998, the word deflation was being heard for the first timesince the 1930s. This happened as a result of the Asian currency crisis thatgripped the world during 1997 and 1998. Within five years, global deflationhad spread from Asia and was starting to infect global bond and stock markets everywhere—including the United States. More than any other factor,the reappearance of deflation changed intermarket relationships that hadexisted over the prior forty years. These changes are why I am writing thisbook—to show what has worked according to the older intermarket modeland, more importantly, what has changed. Intermarket analysis is based onrelationships (or correlations) between markets. It is not, however, a staticmodel. Correlations between financial markets can change over time. Theydo not change randomly, however; there is usually a good reason. The mainreason for some of the changes that started in the late 1990s was the growingthreat of deflation.
THE DEFLATION SCENARIOIn the 1999 revision of my book Technical Analysis of the Financial Markets, I included a chapter on intermarket analysis which reviewed the historicrelationships that had been working for several decades. I also added a newsection which was entitled “Deflation Scenario.” This section described thecollapse in Asian currency and stock markets starting in the middle of 1997;the severe decline had an especially depressing effect on global commoditymarkets like copper, gold, and oil. For the first time in generations, analystsstarting expressing concern that a beneficial era of disinflation (when pricesare rising at a slower rate) might turn into a harmful deflation (when prices ofgoods actually fall). How the markets reacted to that initial threat of deflationdefined the intermarket model for the next five years. Commodity prices fellwhile bond prices rose. This was nothing new—falling commodity pricesusually produce higher bond prices. What changed, though, was the relationship between bonds and stocks. During 1998, stocks were sold all over theworld while money poured into U.S. Treasury bonds in a global search for
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safety. In other words, stocks fell while bonds rose. This was unusual andrepresented the biggest change in the intermarket model. Disinflation (whichlasted from 1981 through 1997) is bad for commodities but is good for bondsand stocks. Deflation (which started in 1998) is good for bonds and bad forcommodities—but is also bad for stocks. In a deflationary climate, bondprices rise while interest rates fall. Falling interest rates, however, do nothelp stocks. This explains why a dozen easings by the Federal Reserve in theeighteen months after January 2001 were unable to stop a falling stock market that had peaked at the start of 2000.
INTERMARKET MODEL FROM 1980 TO 1997This book begins with a quick review of the 1980s, starting with the big intermarket changes that helped launch the greatest stock bull market in history.We will also revisit the 1987 stock market crash—because of its importance inthe development of intermarket theory and its role in changing this theory intoreality. The 1990 bear market was just starting as I was completing my earlierbook. We will study this year in more depth, especially given its relevance toglobal events thirteen years later. Traditional intermarket relationships heldup quite well during the 1994 bear market and continued to do so until 1998.
THEN CAME 1998 AND THINGS CHANGEDThe rest of this book deals with market events from 1998 onwards. That yearrepresented a sea change in the intermarket model. We will study marketforces leading up to the bursting of the stock market bubble in the spring of2000—and the ensuing three years of stock market decline. Deflation plays akey role from 1998 on. Global markets became very closely correlated duringthe late 1990s and the first three years of the new millennium. This wasmainly due to global overinvestment in technology stocks during the latterstages of the Nasdaq bubble—and the ensuing global collapse after the bubble burst. Deflationary trends were also global in scope. The fact that virtually all world markets collapsed together after 2000 called into question thewisdom of global diversification (when stock investments are made in foreign markets to reduce overall risk). During global bear markets in stocks, allworld markets become closely correlated to the downside. This happenedduring the crash of 1987—and again after 2000. It was also another manifes-
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tation of the intermarket reality that financial trends are usually global innature. This includes the direction of stock markets, interest rates, currencymarkets, and trends in inflation and deflation.
THE ROLE OF OILIn 1999, rising oil prices set in motion a series of events that led to the startof a bear market in stocks in the spring of 2000 and the onset of a recessiona year later in the spring of 2001. Rising oil prices have contributed to virtually every U.S. recession in the last forty years. 1999 was no exception. Thesurge in oil prices led the Federal Reserve to tighten interest rates, whichhelped end the longest economic expansion since the 1960s. This action bythe Fed led to an inverted yield curve as 2000 started; this is a classic warning sign of stock market weakness and impending recession. All of thesetrends were clearly visible on the price charts at the time, a fact which isdemonstrated in the book. Unfortunately, the economic community—together with most Wall Street analysts—either did not see the classic warning signs of trouble or simply chose to ignore them.Another change from my previous book is the increasingly importantrole that sector rotation plays in intermarket work. Different stock marketsectors take over market leadership at different points in the economic cycle.In 1999, oil stocks were the market’s strongest sector. This is usually a badsign for the economy and the stock market. You will see how valuable sector“signals” were during the crucial years of 1999 and 2000—and how somedefensive market sectors started new uptrends just as the Nasdaq peaked.
THE RESURGENCE OF GOLDDuring the twenty years from 1980 to 2000, gold was in a major downtrend.This was due to the disinflationary trend of that two-decade period and to thefact that gold generally does poorly during bull markets in stocks. Becausegold is bought mainly during times of crisis, there is not much need for it during a super bull market in stocks. A strong dollar during most of those yearsalso kept gold out of favor. This started to change in 2000, however. Duringthat watershed year, the twenty-year bull market in stocks came to an end. Atthe same time, a seven-year bull market in the U.S. dollar was ending. Thesetwo factors combined to light a fire under a moribund gold market. Over the
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next three years, gold stocks were the top-performing stock market sector.Interestingly, the gold rally started in 2000—right around the time that deflationary talk started to get louder. This puzzled investors, who believed thatgold could only be used as an inflation hedge. History shows that gold stocksdid very well in the deflationary climate of the 1930s. Gold’s historic role hasbeen as a store of value during times of economic upheaval. Another reasonfor gold’s popularity in deflationary times is the Federal Reserve’s attempt toreflate the economy. It does this by weakening the dollar in an attempt to create a little inflation, which in turn boosts the price of gold. The Fed tried thisin the 1930s and in its more recent battle against deflation in the early 2000s.The strategy worked during the 1930s and appears to be working again seventy years later.
ASSET ALLOCATION AND ECONOMIC FORECASTINGIntermarket work has important applications in the areas of asset allocationand economic forecasting. It has long been accepted that the stock market isa leading indicator of the economy. A classic example of this occurred whenthe U.S. market peaked in March of 2000. It took the economic world twelvemonths—until March of 2001—to officially declare that a U.S. recession hadstarted. Markets have a way of looking into the future to “discount” economic trends as far away as six months. This is true for all, including the dollar, bonds, and commodities markets. Commodities give us an early warningof deflationary or inflationary trends. The dollar does the same. The directionof bonds tells us whether interest rates are rising or falling—which tells us alot about the strength or weakness of the economy. And all of these trendssubsequently affect the direction of the economy and the stock market.More importantly, intermarket work helps us to determine which part ofthe financial spectrum offers the best hope for potential profits. From 2000through 2002, for example, deflationary tendencies made bonds a muchstronger asset class than stocks. At the same time, a falling dollar made goldan attractive alternative to stocks. By charting these intermarket trends,investors have a better of chance of being in the right asset class at the righttime—and out of the wrong ones.By the end of 2002, longer-term intermarket charts were hinting that hardassets (like gold and other commodities) were starting to take precedenceover paper assets (like bonds and stocks) for the first time in twenty years.Charts also showed that the housing sector was one of the few bright spotsin an otherwise disappointing stock market and a sluggish economy. Inter-
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market analysis showed that the resiliency in REITs and homebuildingstocks was closely linked to the historic drop in interest rates to their lowestlevel in forty-five years. Charts also showed that 2003 started to see somerotation out of bonds and back into stocks for the first time in three years.This was good for the stock market and the economy, but hinted that theboom in Treasury bonds was nearing completion. Weakness in the dollar andfirmer commodity prices also threatened to boost long-term interest rates.This could be bad for the housing sector which had been thriving on falling long-term rates. Although there are no guarantees that those trends willcontinue, they are examples of how some knowledge of intermarket charting can play an important role in economic analysis and the asset allocationprocess.
IMPORTANCE OF CHARTSAll of this may start sounding like a lot of economic theory. This is partiallythe case, for intermarket analysis is based on economic principles. However,it is not theory. Intermarket work is market-driven. There is nothing theoretical about a profit and loss statement. Economists look at statistics todetermine the direction of the economy and, by inference, the direction offinancial markets. Chartists look at the markets themselves. This is a big difference. While economic statistics are usually backward-looking, the markets are forward-looking. It is much like comparing the relative merits ofusing a lagging or a leading indicator. Given the choice, most people wouldchoose the leading indicator. This goes to the heart of technical analysis.One of the basic premises of the technical approach is that the price actionin each market (and each stock) is also a leading indicator of its own fundamentals. In that sense, chart analysis is just a shortcut form of economic andfundamental analysis. This is also why the intermarket analyst uses charts.Another reason that chartists have such a big advantage in intermarketwork is that they look at so many different markets. Charts make a dauntingtask much simpler. In addition, it is not necessary to be an expert in any ofthe markets. All one needs to do is determine if the line on the chart is goingup or down. Intermarket work goes a step further by determining if tworelated markets are moving in the same direction or in the opposite direction.It does not matter if the charts being compared are those of gold, bond yields,the dollar, the Dow, or the Japanese stock market. You do not have to be acharting expert to do intermarket work, either. The ability to tell up fromdown is all that is needed. And an open mind.
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CHAPTER 1
A Reviewof the 1980s
o fully understand the dramatic turns in the financial markets thatstarted in 1980, it’s necessary to know something about the 1970s.That decade witnessed a virtual explosion in commodity markets,which led to spiraling inflation and rising interest rates. From 1971 to 1980,the Commodity Research Bureau (CRB) Index—which is a basket of commodity prices—appreciated in value by 250 percent. Bond yields rose by150 percent during the same period and, as a result, bond prices declined.Figure 1.1 shows the close correlation between the CRB Index and theyield on 10-year Treasuries between 1973 and 1987. Long-term rates rosewith commodities during the inflationary 1970s and fell with them duringthe disinflationary 1980s.The 1970s were not good for stocks, either. The Dow Jones IndustrialAverage started the decade near 1,000 and ended the decade at about thesame level. In the middle of that 10-year period of stock market stagnation,the Dow lost almost half its value. The 1970s were a decade for tangibleassets; paper assets were out of favor. By the end of the decade, gold priceshad soared to over $700 per ounce. A weak dollar during that period alsocontributed to the upward spiral in gold and other commodity prices—aswell as the relative weakness in bonds and stocks. All this started to changein 1980, when the bubble burst in the commodity markets. Figure 1.2 is aratio of the Dow Industrials divided by the gold market. The plunge in thisratio during the 1970s reflected the superior performance by gold and otherhard assets in that inflationary decade. The ratio bottomed in 1980 after goldpeaked. The Dow then bottomed in 1982.
T
1
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INTERMARKET ANALYSIS
FIGURE 1.1
A demonstration of the positive correlation between the CRB indexand 10-year Treasury yields from 1973 to 1987.
COMMODITIES PEAK IN 1980In late 1980, the bubble in commodity prices suddenly burst. The CRB Indexstarted to fall from a record level of 330 points—and began a 20-year declineduring which it lost half of its value. During these same 20 years, gold pricesfell from $700 to $250, losing over 60 percent of their value. (It was not untilafter the stock market peak in 2000 that gold prices started to show signsthat their twenty-year bear hibernation had ended.) The 1980 peak in commodity markets ended the inflationary spiral of the 1970s and ushered in anera of falling inflation (or disinflation) that lasted until the end of the twentieth century. Figure 1.3 shows the dramatic rally in a number of commodity indexes during the 1970s and the major peak that occurred in 1980.Commodity prices declined for the next 20 years. Another financial market
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A Review of the 1980s
FIGURE 1.2
3
The plunge in the ratio during the 1970s reflected the superior performance ofgold during that inflationary decade.
made a big turn in 1980 that had a lot to do with the big peak in commodities: the U.S. dollar.
DOLLAR BOTTOMS IN 1980The U.S. dollar hit a major bottom in 1980 and doubled in price over the nextfive years. One of the key intermarket relationships involved is the inverserelationship between commodity prices and the U.S. dollar. A falling dollar isinflationary in nature, and usually coincides with rising commodity prices(especially gold). A rising dollar has the opposite effect and is bearish forcommodities and gold. This is why the significant upturn in the U.S. currencyin 1980 was such an important ingredient in the historic turn from hyperinflation to disinflation that characterized the next 20 years. (Starting in year2002, a major decline in the U.S. dollar contributed to a major upturn in goldand other commodities.)
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FIGURE 1.3
INTERMARKET ANALYSIS
A number of commodities indexes show the dramatic rally during the 1970sand the major commodity peak during 1980.
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A Review of the 1980s
5
BONDS BOTTOM IN 1981Another key intermarket relationship has to do with bond and commodityprices. They trend in opposite directions. Rising commodity prices (like thoseseen in the 1970s) signal rising inflation pressure, which puts upward pressure on interest rates and downward pressure on bond prices. (Bond pricesand bond yields trend in opposite directions.) Commodity prices oftenchange direction ahead of bonds, which also makes them leading indicatorsof bonds at important turning points. At the start of the 1980s, it took a yearfor the drop in commodities to push the bond market higher.During the second half of 1981, bond yields peaked near 15 percent. Theyfell to half that level (7 percent) within five years, which caused a majorupturn in bond prices. The tide had turned. The stock market, which hadbeen held back for a decade by rising interest rates, soon got an enormousboost from falling bond yields (and rising bond prices).
STOCKS BOTTOM IN 1982During the summer of 1982, within a year of the bond market bottom, thebiggest bull run in stock market history started—and lasted for almost twodecades. The fact that the bond market bottomed ahead of stocks is alsopart of the normal pattern. The bond market has a history of turning ahead ofstocks and is therefore viewed as a leading indicator of the stock market. Theintermarket scenario had completely reversed itself at the start of the 1980s.Hard assets (like commodities) were in decline, while paper assets (bondsand stocks) were back in favor.This turning point was one of the clearest examples of how intermarketrelationships play out. Notice that four different market groups were involved: currencies, commodities, bonds, and stocks. All four played a majorrole as the inflationary 1970s ended and the disinflationary 1980s began. Let’sreview the groundrules for how the financial markets normally interact witheach other, which form the basis for our intermarket work.
HOW THE FOUR MARKET GROUPS INTERRELATEIntermarket analysis involves the simultaneous analysis of the four financialmarkets—currencies, commodities, bonds, and stocks. It is how these four
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