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FIGURE 5.13
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A close correlation is seen between commodities and the Hang Seng Indexfrom 1997 to 1999.
on commodity prices (owing to deflation fears). Figure 5.13 shows the closecorrelation between the Hang Seng Index and commodity prices from the middle of 1997 through the middle of 1999. The Hang Seng Index peaked in July1997. Commodity prices peaked three months later (although industrial metalspeaked with the Hong Kong market over the summer). The Hang Seng Indexbottomed during the third quarter of 1998. Commodity prices started bottoming shortly thereafter. By the start of 1999, the Hong Kong stock market andcommodity prices were rising together. The deflationary fears coming fromAsia in 1997 and throughout most of 1998 gave way to inflationary fears at thestart of 1999. Falling Asian stocks pulled commodity prices down in 1997. Bythe start of 1999, rising Asian stocks were pulling commodity prices higher.(To carry the link with Asia a step further, the next chapter examines the closecorrelation between U.S. interest rates and the Japanese stock market, especially in the years after 1997.)
HONG KONG AND SEMICONDUCTORSThe direction of the Hong Kong stock market also has a strong influence onthe direction of the semiconductor group. Figure 5.14 shows the close cor-
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FIGURE 5.14
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A close correlation is seen between the SOX Index and the Hong Kong stockmarket from 1997 to 1999.
relation between the Hang Seng Index and the Semiconductor (SOX) Indexfrom 1997 to 1999. Both markets peaked together during the summer of1997 and then bottomed together during the third quarter of 1998. The rallyin Hong Kong in 1999 helped make the semiconductor group one of thatyear’s strongest performers. Their strong linkage has to do with the factthat most of the world’s semiconductors are produced in Asia. As a result,the health of the semiconductor sector is closely tied to the health of theAsian economy.
THE AUSTRALIAN DOLLAR AND COMMODITY PRICESThe Australian and Canadian currencies are closely tied to commodityprices (especially the Australian dollar). Both countries are big producersof natural resources. Figure 5.15 shows the strong link between the Australian dollar and the price of copper from 1997 to 1999. During the Asiancrisis of 1997, the Australian dollar fell sharply along with copper (andcommodity prices in general). The Australian dollar bottomed during the thirdquarter of 1998 just as the rest of the Pacific Rim was stabilizing. The rally
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Australian DollarCopper Futures - COMEX
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FIGURE 5.15
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A stock link is seen between copper and the Australian Dollar from 1997to 1999.
in the Australian dollar off that late 1998 bottom was an early sign of abottom in commodity prices (like copper), which followed a few monthslater. (Chapter 10 discusses how a big commodity rally that started during2002 helped make the Australian and Canadian dollars two of the world’sstrongest currencies.)
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CHAPTER 6
Reviewof IntermarketPrinciples
INTRODUCTIONWe have ended our coverage of the 1990s. But before examining the more difficult years after 2000, let us pause long enough to review just what intermarket analysis is. How does it add to traditional technical analysis? Whatare its applications to other areas of study including asset allocation, sectorrotation, and even economic forecasting? It is also a good time to explainwhy technical analysis lends itself so well to this form of analysis, whichrequires the study of so many markets. This chapter also restates the basicprinciples on which intermarket analysis is based.
AN EVOLUTIONARY STEP IN TECHNICAL ANALYSISOver the past century, technical analysis was based primarily on single market analysis. This meant, for example, that stock market analysts looked onlyat stock market charts. Bond, commodity, and currency chartists looked only atcharts of the market in which they were trading. Over the past decade, however, emphasis in the technical world has shifted away from single marketwork to a more intermarket approach. It is not unusual for technical analyststo supplement their stock market analysis with consideration of currencytrends (to see where global money is flowing), commodity prices (to gaugeinflationary trends), bond charts (to see which way interest rates are moving), and overseas markets (to measure the impact of global market trends).Those who fail to do so run the risk of seeing only a small part of the inter81
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market picture. In an increasingly interrelated financial world, the ability tostudy all markets gives intermarket technical analysts a huge advantage. Withsome understanding of how the markets interrelate, chartists have a decidededge over their economic and fundamental counterparts.
EMPHASIS ON SECTOR WORKAlthough intermarket principles are invaluable in understanding how bonds,stocks, commodities, and currencies work off each other, it has also provento be extremely helpful in understanding why certain sectors of the marketdo well at certain times and badly at others. An understanding of intermarketprinciples sheds new light on the application of sector rotation, which hasbecome so important in recent years. It is no longer so much a question ofwhether or not to be in the market as much as it is where to be in the market.(Although a big bear market started in the stock market during the spring of2000, money could still be made by rotating into defensive stock groups thatstarted to rise as the rest of the market fell.) Being in the right sector at theright time (and out of the wrong sectors) has become one of the keys tostock market success. Fortunately, all kinds of charting tools exist to helpinvestors do that.
ASSET ALLOCATION STRATEGIESThere are times when even sector work has its limitations, such as whenstocks are in the midst of a major bear market. At such times, asset allocationstrategies come into play. This might involve rotating out of stocks intobonds, raising one’s cash exposure with a money market fund, or even buying gold shares. All of these strategies worked in the three years following thestock market top in 2000. Fortunately, there are charting tools to helpinvestors with these decisions as well. These tools do, however, require someknowledge of intermarket principles.
THE BASIC PREMISE OF INTERMARKET ANALYSISThe basic premise of intermarket analysis is that all markets are related. Inother words, what happens in one market has an effect on another. On amacro level, the four interrelated markets are the commodity, currency,
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bond, and stock markets. Market analysts have long understood the impactof interest rates on stocks, for example. Rising interest rates have historicallybeen bad for stocks, especially those in interest rate-sensitive market sectors.Interest rates are affected by the direction of commodity prices. Rising commodity prices are usually associated with rising inflation, which puts upwardpressure on interest rates. Commodity prices and interest rates are influenced by the direction of a country’s currency. (Because global commoditiesare quoted in U.S. dollars, the direction of the dollar has an influence on thedirection of global commodity prices like gold.) A falling currency usuallygives a boost to commodity prices quoted in that currency. This boost incommodity prices reawakens inflation fears and puts pressure on centralbankers to raise interest rates, which has a negative impact on the stock market. Not all stocks, however, are affected equally. Some stocks get hurt in aclimate of rising interest rates; others actually benefit.
GLOBAL MARKETSGlobal markets play an increasingly important role in intermarket analysis.The bear market years of 1987, 1990, and 1994 showed that world stock markets usually fall together at such times. As evidenced by the Asian currencycrisis that started in 1997, currency trends, commodity trends, and interestrate trends are global in scope and have a major impact on each other. The1970s witnessed a bout of hyperinflation that was global. The 1980s and 1990ssaw disinflationary trends that were evident worldwide. As a result, globalcommodities were generally weak during those two decades, while global bondand stock markets were strong. At the turn of the new millennium, deflationary trends that started in Asia affected world markets everywhere. During the three years following the bursting of the stock market bubble in 2000,the world’s equity markets fell together in a dramatic demonstration of globallinkages. As was demonstrated during the first and second Iraq wars in1990–1991 and 2002–2003, a spike in the price of crude oil has a depressingeffect on major stock markets and economies all over the planet.
GLOBAL SECTOR TRENDSGlobal influences are also present on a sector-by-sector basis. When one seessector strength or weakness, the trends are normally present on a worldwidebasis. Because macro intermarket trends are usually global in scope, so is
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110.0%
General Motors Corp.Toyota Motor Corp.
100.0%90.0%80.0%70.0%60.0%50.0%40.0%30.0%20.0%10.0%0.0%-10.0%-20.0%© StockCharts.com 2003
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FIGURE 6.1
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American and Japanese auto stocks trend in the same direction.
their impact on global market sectors and industry groups. Semiconductorstocks, for example, tend to rise and fall together all over the world; the sameis true for other stock groups. When it is a good time to buy a Japanese autostock, it is usually also a good time to buy auto stocks all over the world.They rise and fall together based on global economic trends. Figure 6.1 compares the price history of General Motors and Toyota over the last five years.It is hard to tell the two auto stocks apart even though one is an American carmanufacturer and the other one Japanese. Figure 6.2 compares the pricetrends of Intel Corporation and Taiwan Semiconductor since 1998. The twosemiconductor manufacturers move up and down together despite the factthat one is based in Taiwan and the other in Santa Clara, California. Sectorand industry trends are global in nature and transcend national boundariesand geographic regions.
JAPAN’S EFFECT ON U.S. MARKETSEven a market as far away as Japan affects market trends in the United States.One demonstration of that impact is seen by comparing the Japanese stockmarket with the yield on the U.S. 10-year Treasury note. This comparison shows
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Intel Corp.Taiwan Semiconductor Mfg
© StockCharts.com 2003
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FIGURE 6.2
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American and Taiwanese semiconductor stocks trend together.
a striking correlation over the past several years. (See Figure 6.3.) Although itmay seem strange at first, the chart makes perfect sense. Japan has the secondlargest economy in the world. For most of the past decade, the Japanese economy has been in a deflationary recession (or depression), which in turn has contributed largely to the global downtrend in long-term interest rates.Global interest rates peaked at the start of the 1980s and fell for the nexttwo decades as disinflationary forces reigned. The Japanese market peaked atthe start of the 1990s and fell for the following decade. The fall in the world’ssecond largest stock market may have provided the first warning of the start ofa deflationary trend. This threat took on more meaning after the Asian currency crisis of 1997, which was the second deflationary warning. This mayexplain why the linkage between U.S. interest rates and Japan became especially close around 1997. Figure 6.3 shows that both markets peaked togetherin 1996 and fell together through the Asian crisis years of 1997 and 1998. TheNikkei 225 and 10-year T-note yield bottomed together in the autumn of 1998and rose together throughout 1999. (The previous chapter discusses how therecovery in Asia in 1999 helped boost industrial commodity prices, but pushedglobal interest rates higher.)The two markets fell together again at the start of 2000. Within threeyears, both markets had fallen to the lowest levels in decades. One of the
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FIGURE 6.3
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A close correlation exists between U.S. bond rates and the Nikkei.
main reasons for this remarkably close correlation between Japanese stocksand U.S Treasury note rates since 1997 is that the deflationary trend thatstarted in Asia a decade before started to gain more attention after the Asiancurrency crisis. It also explains why it is important for American investors tounderstand trends in other global markets.
JAPAN EFFECT OVERRIDES THE FEDAfter the stock market bubble burst in the United States in 2000, the FederalReserve lowered interest rates 12 times over eighteen months in an attemptto stop the bear market in stocks and stabilize the American economy. It didnot work. Part of the reason it did not work was the influence of deflationarytrends coming from Asia. By year 2002, even the Fed was using the D-word(deflation), although it was mainly in denial of its threat. That the FederalReserve felt the need to make the denial at all suggested that it was indeed athreat. Intermarket chartists who studied the trends in Asia—and comparedthem to those in the United States—recognized this threat a few years earlier.(Later in the book, we will see that one of the tactics that the Fed used to
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combat the deflationary threat in the United States was to lower the dollar inan attempt to create a little price inflation.)
ECONOMIC LESSONSThe reaction of the economic community in 1999 and then again after 2000was instructive—and demonstrates the need to study global forces. In 1999,rising commodity prices contributed to higher interest rates. Many U.S. economists spent most of 1999 questioning the rise in U.S. interest rates in the faceof relatively low inflation. What they apparently failed to realize was that theupturn in U.S. interest rates in 1999 may have had more to do with a reboundin Asian markets and less to do with the U.S. economy. After 2000, economistsalso wondered why U.S. rates continued dropping in the face of so much stimulus from the Fed. After all, they argued, the United States was not in an outright deflation (which would have justified such low U.S. rates). Once again,American economists failed to look abroad. The deflationary trend in U.S.rates was largely the result of deflationary trends in the Far East. One did nothave to be an economist to study price charts in commodity prices, bondyields, and the Japanese stock market, and to see that all three were fallingtogether. As is usually the case, market trends anticipate economic trends.
THE TECHNICAL NATURE OF INTERMARKET ANALYSISIt is difficult to separate market trends from economic trends. Economistshave known for years that bond and stock markets anticipate economictrends (although it is amazing how often they ignore these market signs).This is where the technical analyst comes in. The technical analyst (who isprobably more aptly called a market analyst) is mainly interested in markettrends. If these market trends have some application to economic forces (andthey do), so be it. But these economic trends usually show up in the financialmarkets first, where the intermarket chartist can easily spot them.
ADVANTAGES OF CHARTING—THE BIG VIEWOne of the main advantages that technical analysts have is the ability to plotseveral markets at the same time. They can easily chart the course of the dollar, oil, bonds, and the stock market. They can also chart the relative performance of stock market industry groups and sectors. It is also a simple task to
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chart and analyze the trends of major global stock markets. The ability to chartso many things at the same time gives the technical analyst a big edge in thearea of intermarket analysis over those who lack this skill. Once the numerousmarkets are charted, the next logical step is to study their interrelationships.Fundamental analysts, by contrast, tend to specialize in fewer marketgroups. The nature of fundamental analysis, with its emphasis on companyand industry earnings, demands more specialization. Can you imagine aneconomist trying to master the intricacies of the Japanese economy as wellas all of the world’s major economies? The chartist has a unique advantagewhen it comes to grasping the big picture. More and more, some grasp of thebig picture—both domestically and globally—is a necessary ingredient tohaving a thorough market view.
ECONOMIC FORECASTINGAwareness of the financial markets’ intermarket condition also sheds light onwhy certain market sectors do better or worse at certain times. This insight,combined with relative strength (or ratio) charts, is invaluable in the implementation of sector rotation strategies. These sector rotations also shed lighton the current state of the economy (as is depicted graphically in the nextchapter concerning the events of 2000). Because financial markets act as leading indicators for economic trends, intermarket analysis elevates the usefulness of technical analysis to the realm of economic forecasting. The stockmarket top in the spring of 2000 correctly predicted the onset of a recessiontwelve months later, a warning that most economists and Wall Street securityanalysts chose to ignore. They ignored another traditional warning sign duringthe first quarter of 2000 that was clearly seen on the charts—an inverted yieldcurve occurred at the start of 2000 when short-term interest rates exceededlong-term rates, and warned of economic weakness.
MARKETS ANTICIPATE ECONOMIC TRENDSOne of the basic premises of technical analysis is that the markets discounteconomic and fundamental information. This simply means that the financialmarkets anticipate economic trends six to nine months into the future. Thejob of the chartist is to study the markets in an attempt to decipher their message about future trends, both in the markets and the economy. Nowhere isthis more true than in the field of intermarket analysis. Financial markets
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always carry a message. The trick is knowing how to read the message (andthen paying attention to it). It can best be done by tracking all of the markets—not just one or two—and taking all of their interrelationships intoconsideration. As is discussed in subsequent chapters, some knowledge ofintermarket principles—along with some rudimentary chart-reading skills—could have saved a lot of people a lot of money in the bear market years thatstarted with the new millennium.
THE ROLE OF THE DOLLARThe three asset classes that get most of our attention in intermarket work arestocks, bonds, and commodities. These three markets normally peak andtrough in a predictable order depending on the state of the economy. Nearthe end of an economic expansion, for example, commodity prices are usually strong, while bond prices are weak. Bonds peak before stocks do. Commodities usually peak last. During a recession, commodity prices fall whilebond prices rise. Bonds bottom before stocks do. Commodities bottom last.Currency markets play a role in the intermarket picture, but in a moreindirect way. The influence of the dollar on bonds and stocks is usually filtered through its influence on commodity markets. If a falling dollar pushescommodity prices higher, it is usually bearish for bonds and, in time, stocksas well. Even so, the direction of the dollar and foreign currencies sendimportant economic messages and have an influence on other markets.
GLOBAL IMPACT OF CURRENCY TRENDSA falling dollar results in higher foreign currency values. Global investmentfunds tend to flow toward countries with stronger currencies. Stronger currencies are the result of higher interest rates, which reflect stronger economic conditions in a particular country. A weak currency sends the oppositemessage. A strong currency also increases the appeal of a country’s bondsand stocks to foreigners. For an American investor, a weak dollar increasesthe appeal of foreign bonds and stocks. At the same time, a weak dollardiminishes the appeal of U.S. assets for foreign investors. Not all countriesbenefit equally, however, from rising currency trends. Countries that relymore heavily on exports (like Europe and Japan) may actually suffer whentheir currency rises too far too fast, because it hurts their export business. (InGermany, which has the biggest economy in Europe, exports account for a
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third of its gross domestic product.) As a result, the intermarket impact thatthe U.S. dollar has on American markets may not have exactly the sameapplication in all foreign markets. Even within the U.S. market, there arequalifications that have to be made regarding the dollar. The direction of theU.S. dollar does not affect all American stocks equally.
DOLLAR IMPACT ON MULTINATIONALSLarge multinational stocks derive a big portion of their earnings from overseas sales. As a result, a rising dollar can have a negative impact on these foreign sales. By the same token, a falling dollar may actually help. This is truefor two reasons. First, a falling dollar makes U.S. products more competitivein world markets, whereas a rising dollar makes them less competitive. Second, foreign sales by U.S. corporations have to be “exchanged” for U.S. dollars. If the euro, for example, is stronger than the dollar, the exchange out ofeuros and into dollars results in more dollars.
MCDONALDS AND PROCTER & GAMBLEPROFIT FROM WEAK DOLLAROn April 23, 2003, the Dow rose 165 points to record its biggest one-day gain inthree months. Two of the top Dow gainers were McDonalds and Procter &Gamble. The headline in The New York Times the next day read “Weak DollarValue Helps McDonalds Return to Profit.” The Times reported that much ofthe first-quarter gains reported by McDonalds came from a 2 percent increasein profit from the conversion of strong foreign currencies like the euro into theweaker dollar. Procter & Gamble, a multinational consumer products firm,gets half of its sales from overseas. Strong foreign currencies (combined witha weaker dollar) added 3 percent to that firm’s first-quarter profit.
DOLLAR IMPACT ON DRUG STOCKSDrug stocks provide another example of a multinational stock group thatcan be impacted by dollar trends. A falling dollar may help the bottom line oflarge multi-national pharmaceutical firms since so much of their revenuecomes from foreign markets like Europe. This may also help explain whydrug stocks usually hold up better than other stocks (on a relative basis)
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Pharmaceutical / S&P 500 Ratio
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FIGURE 6.4
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Drugs have outperformed the S&P since 2000. A falling dollar in 2002 alsohelped drugs.
when the dollar and the stock market are weak. Drug stocks are defensive innature and show better relative strength when the stock market is weak. Atthe same time, a weaker dollar also increases the relative attractiveness ofdrug stocks because of their dependence on foreign sales.Figure 6.4 plots a ratio of the AMEX Pharmaceutical Index (DRG) dividedby the S&P 500 since 1999. The rise in the Drug Index (relative to the S&P500) since the start of 2000 reflects the fact that the defensive drug stocksattract money when the stock market is weak and, as a result, outperformthe general market. While the S&P 500 peaked during 2000, the Dollar Indexdid not start falling until 2002. This dollar weakness during the first half of2002 may account for the boost that the drug stocks got from the middleof 2002 to the middle of 2003. A weak dollar and a weak stock market are usually a good combination for drug stocks.
SMALL STOCKS ARE DOMESTICThe size of a stock may also determine how much it will be affected by dollartrends. Because most multinationals are large firms, they are more affected
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by dollar trends than smaller stocks. Smaller firms rely more heavily ondomestic business and less on foreign sales, so they are less impacted by currency exchange rates. It could be said, therefore, that a rising dollar favorssmall-capitalization stocks more than large-cap stocks, while a falling dollarbenefits large-cap stocks more than small-cap stocks.
WEAK DOLLAR ALSO HELPS SERVICE STOCKSAlthough it is generally recognized that American manufacturers get a boostfrom a weaker dollar, it is not as widely recognized that American servicestocks get a boost as well. American service companies (which include insurance, retailers, telecom, and worldwide package delivery services) spentthe 1990s expanding into overseas markets. This put U.S. service-orientedstocks into position to benefit from a weaker dollar. Figure 6.5 shows thatUPS (United Parcel Service) appears to have benefited from a weaker dollarwhich started falling at the start of 2002.
15.0%
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UPS benefited from a weak dollar after 2001. A falling dollar helpsservice companies.
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RECAP OF INTERMARKET PRINCIPLESBefore we end our discussion of the profitable 1990s and being to examinethe more difficult years after 2000, let’s review the main intermarket principles covered in the preceding chapters. These are the intermarket relationships that ruled the markets over the last 30 years of the twentieth century.Some of them started changing in the late 1990s.