Inc.)
With industrial metals rising throughout the year, copper and aluminumstocks (and basic material stocks in general) did well in 1994 despite thefact that it was an otherwise dismal year. Figure 3.9 shows nonferrousmetal stocks rising along with copper during 1994 and profiting accordingly.In the stock market as in real estate, the name of the game is location. In1994, aluminum and copper stocks were a good place to be while utilitieswere not. (We will cover sector rotation more thoroughly in Chapter 13.)
03_chap_murphy.qxd 10/31/03 12:51 PM Page 46
46
INTERMARKET ANALYSIS
FIGURE 3.9
The bottom in copper prices may have been bearish for bondsand utilities, but was bullish for related metal stocks.(MetaStock, Equis International, Inc.)
INTERMARKET PICTURE REVERSES IN 1995The normal rotation among the three assets classes is this: commodities turnfirst, bonds turn second, and stocks turn last. A bottom in commodity pricesin 1993 preceded a top in bond prices, which was followed by a top in stockprices. This is the normal rotation. The intermarket rotation that unfoldedin late 1994 and early 1995 followed this same order, but in the opposite
03_chap_murphy.qxd 10/31/03 12:51 PM Page 47
The Stealth Bear Market of 1994
47
direction. The CRB Index peaked in the middle of 1994 (and traded sidewaysfor the next year). Bond prices bottomed during November. Stocks bottomedwithin a month of bonds. Once again, the normal intermarket rotationoccurred. Commodities peaked first, followed by a bottom in bonds, followed by a bottom in stocks. Once again, copper proved to be a coincidentas opposed to a leading indicator for bond prices and utilities.Figure 3.10 shows copper peaking near the end of 1994 just as the bondmarket was bottoming. Utilities bottomed along with bonds just as the price
FIGURE 3.10
At the start of 1995, the peak in copper prices coincidedwith an important bottom in bond prices. (MetaStock, EquisInternational, Inc.)
03_chap_murphy.qxd 10/31/03 12:51 PM Page 48
48
INTERMARKET ANALYSIS
of copper was peaking. Figure 3.11 shows the bond bottom in late 1994occurring just ahead of a major bottom in the stock market. The U.S. dollar,which had been falling throughout 1994, turned up in the spring of 1995 andbegan a seven-year bull market. The stronger dollar had a dampening effecton commodities, but helped bonds and stocks.
FIGURE 3.11
Weakness in bond prices during 1994 caused a 10 percentcorrection in stock prices and a year of consolidation. The late1994 bottom in bonds helped launch another bull leg instocks. (MetaStock, Equis International, Inc.)
03_chap_murphy.qxd 10/31/03 12:51 PM Page 49
The Stealth Bear Market of 1994
49
THE CRB/BOND RATIOAnother simple indicator which is especially helpful in determining whetherone’s portfolio should be emphasizing inflation- or rate-sensitive stocks isthe CRB/bond ratio. This simple ratio divides the price of the CRB Index (orany commodity index) by the price of Treasury Bonds (or T-Notes). The ratiois a measure of relative strength, a concept that is explored more fully laterin the book. When the CRB/bond ratio is rising, commodity prices are outperforming bond prices. In such a climate, commodity markets (or commodity-related stocks) should be emphasized. Commodity-related stocks includebasic materials and natural resources, such as aluminum, copper, gold mining, and energy. These are stocks that tend to outperform the general marketduring periods of rising inflation. Figure 3.12 shows the CRB/bond ratioadvancing during most of 1994 and then peaking during the fourth quarter.The CRB/bond ratio turned up in late 1993 and continued to rise foralmost a year. This was during a period of time when copper stocks rose andutilities tumbled. A rising CRB/bond ratio is generally negative for the stockmarket, since it signals rising inflation and higher interest rates. (The negative influence of rising commodities on stocks holds true during inflationaryand disinflationary periods—but not necessarily during a deflation. In a deflation, rising commodity prices are generally positive for stocks.) This alsohelps explain why 1994 was a difficult year for stocks and rate-sensitivestocks in particular. The peak in the ratio in November 1994 signaled a shiftin the asset allocation mix away from commodity-type stocks and back torate-sensitive stocks (and stocks in general). The peak in the CRB/bond rationear the end of 1994 helped set the stage for a strong stock market advancethat lasted until 2000.
BONDS AND STOCKS RISE TOGETHER UNTIL 1998From their bottom during the fourth quarter of 1994, stocks began a phenomenal bull run that lasted until the end of the decade. During those fiveyears, the Dow went from under 4,000 to nearly 12,000—more than a tripling inprice. This gain was dwarfed by the technology-dominated Nasdaq market—it rose from 700 to 5,000 in those same five years, increasing its 1994 value byseven times. The stock market got a lot of help from the U.S. dollar during thefive-year bull run. The U.S. Dollar Index rose from a value of 85 near thestart of 1995 to 120 by 2000 for a gain of 40 percent. Commodity prices fell
03_chap_murphy.qxd 10/31/03 12:51 PM Page 50
50
INTERMARKET ANALYSIS
FIGURE 3.12
A rising ratio signals inflationary pressure, which is generallynegative for stocks (1994). The peak in the ratio in early1995 was negative for commodities, but bullish for bothbonds and stocks. (MetaStock, Equis International, Inc.)
throughout most of that period and did not hit bottom until 1999. Treasurybond prices, which had bottomed during November 1994, rose for the nextfour years into the autumn of 1998. Until 1998, the intermarket relationshipsthat had held throughout most of the postwar era remained intact. A risingdollar and falling commodities supported bull markets in bonds and stocks.In 1998, however, some key intermarket relationships started to change.
04_chap_murphy.qxd 10/31/03 12:53 PM Page 51
CHAPTER 4
The 1997Asian Currency Crisisand Deflation
ASIAN CURRENCY CRISIS STARTS IN 1997The intermarket principles that I have described are based on market trendssince 1970. The 1970s saw runaway inflation, which favored commodity assets. The 1980s and 1990s were characterized by falling commodities (disinflation) and strong bull markets in bonds and stocks. Starting in 1997,however, some changes started showing up in the traditional intermarketmodel. The problems started with a currency crisis in Thailand during 1997and climaxed with another one in Russia during 1998. The events of 1997 and1998 provided a dramatic example of how closely linked global marketsreally are, and how a crisis in one part of the world can quickly spread toother parts.During the summer of 1997, the currency of Thailand started to tumble.It was a trend that soon spread to other currencies in that region. The collapse in Asian currency markets caused a corresponding collapse in Asianstock prices, which had a ripple effect around the globe. Fears of globaldeflation pushed commodity prices into a free fall and contributed to aworldwide rotation out of stocks into bonds. Over the following year anda half, the CRB fell to the lowest level in 20 years. The reaction of Asian central bankers to the crisis provided a lesson in intermarket relationships. In anattempt to stabilize their falling currencies, they raised interest rates. Thisjump in interest rates pushed Asian stocks into a sharp decline that lasted forat least a year and had a pronounced effect on all global financial markets.Throughout these hectic two years, all traditional intermarket relationshipsheld up quite well—except for one.51
04_chap_murphy.qxd 10/31/03 12:53 PM Page 52
52
INTERMARKET ANALYSIS
BONDS AND STOCKS START TO DECOUPLEThe most important result of the events of 1997 and 1998 was the decouplingof bonds and stocks. Decoupling means that bond and stock prices trend inopposite directions, rather than adhere to their traditional tendency to trendin the same direction. During the second half of 1997, stock prices in theUnited States declined while Treasury bond prices rose. During the first halfof the following year, stocks rose while bonds declined. During the third quarter of 1998, stocks fell even more sharply as Treasury bond prices soared.From July to October of 1998, the Dow Industrials fell 20 percent. Stock markets sold off all over the world. While stocks were falling, U.S. Treasury bondprices surged to record highs. During these three months of panic stock selling, U.S. Treasuries became the strongest market in the world.By the end of the fourth quarter of 1998, perceptions that the crisis hadpassed caused bonds to tumble and stocks to soar in a complete role reversal of the prior three months. Bonds continued to fall throughout the entireyear of 1999 while stocks soared to new highs. The events of 1997 and 1998contributed to a major decoupling of bonds and stocks, which was to last forseveral years. The changing relationship between bonds and stocks started inthe midst of the Asian currency crisis when a new word started circulatingin financial circles—deflation.
THE DEFLATION SCENARIOIn 1998, I was in the process of revising my first book Technical Analysis ofthe Futures Markets, which included a new chapter on intermarket analysis.After explaining the normal intermarket relationships that had prevailedup to that point, I inserted a section entitled “The Deflation Scenario.” In it Inoted that for the first time since the 1930s, market analysts were worriedthat a beneficial period of disinflation (when prices of goods rise at a slowerrate) might turn into a harmful deflation (when prices of goods actually fall)as a direct result of the Asian meltdown. Asian contagion became a familiarphrase in the financial world. (The Japanese stock market decline thatstarted during 1989 had pushed the world’s second largest economy into adeflationary spiral.) To add to these worries, producer prices in the UnitedStates fell on an annual basis for the first time in more than a decade.During the Asian currency crisis that started in the middle of 1997, investors started selling stocks and buying bonds. The reason for this switch intrading patterns is that deflation changes some of the normal intermarket
04_chap_murphy.qxd 10/31/03 12:53 PM Page 53
The 1997 Asian Currency Crisis and Deflation
53
relationships, but not all. In a deflationary climate, bond prices rise whilecommodity prices fall. This is what happened from the middle of 1997through the fourth quarter of 1998. However, the stock market can react negatively in such an environment. To quote what I wrote back in 1998: “If andwhen deflation does occur, intermarket relationships will still be present butin a different way. Disinflation is bad for commodities, but good for bondsand stocks. Deflation is good for bonds and bad for commodities, but mayalso be bad for stocks.” The section ended with the following paragraph:The deflationary trend that started in Asia in mid-1997 spread to Russia and Latin America by mid-1998 and began to hurt all global equitymarkets. A plunge in commodity prices had an especially damagingimpact on commodity exporters like Australia, Canada, Mexico, andRussia. The deflationary impact of falling commodity and stock priceshad a positive impact on Treasury bond prices, which hit record highs.Market events of 1998 were a dramatic example of the existence ofglobal intermarket linkages and demonstrated how bonds and stockscan decouple in a deflationary world.
1997 AND 1998 WERE ONLY A DRESS REHEARSALThe way the financial markets reacted to the initial deflationary threat during1997 and 1998 was only a “dress rehearsal” for the devastating bear market instocks that started in the spring of 2000. During the worst three stock marketyears since the Great Depression, bond prices rose continuously while stockprices fell. The Fed lowered interest rates 12 times over an 18-month periodwith no apparent effect on stocks. Stocks kept falling along with rates, whichfell to the lowest level in over 40 years. Those who heeded the warnings of1997 and 1998 were on alert that rising bond prices (and falling rates) donot help stocks in a deflationary climate. Those traders and investors whoscoffed at the deflationary threat and kept playing by the old rules paida heavy price in stock market losses and missed big profit opportunitiesin bonds.
INTERMARKET PICTURE DURING 1997 AND 1998In this chapter, we discuss the intermarket relationships surrounding theAsian currency crisis that started during the summer of 1997 and climaxed in
04_chap_murphy.qxd 10/31/03 12:53 PM Page 54
54
INTERMARKET ANALYSIS
the fall of 1998. The main focus is how the markets reacted to each otherfrom the middle of 1997 to the end of 1998. We discuss which relationshipschanged and which ones did not. In the next chapter, the analysis is extendedinto 1999 to show how intermarket trends led to the bursting of the stockmarket bubble the following year.
THE DOLLAR VERSUS COMMODITIESFrom the start of 1994 through the end of 1998, the Dollar Index and commodity prices maintained their normal inverse pattern, as shown in Figure4.1. The U.S. dollar bottomed out during the first part of 1995 and began a bullmarket climb that lasted until the end of that decade. Normally, a rising dollar has a bearish impact on commodity prices. And this is exactly what happened, but with a time lag. After trading sideways from the middle of 1994through the middle of 1995, the CRB Index rose into the early part of 1996.1995 thus saw an unusual pattern of rising commodity prices coinciding with
17.5%
CRB IndexUS Dollar Index
15.0%12.5%10.0%7.5%5.0%2.5%0.0%-2.5%-5.0%-7.5%-10.0%-12.5%-15.0%© StockCharts.com 2003
A
J
FIGURE 4.1
O
A
J
O
A
J
O
A
J
O
A
J
-17.5%
O
Commodities and the dollar moved inversely from the start of 1994 to theend of 1998.
04_chap_murphy.qxd 10/31/03 12:53 PM Page 55
55
The 1997 Asian Currency Crisis and Deflation
a rising dollar. By the start of 1996, however, the CRB Index hit a major peakand fell for the following three years. For these three years, commodityprices fell while the dollar rose. The normal inverse relationship betweenthese two markets was particularly evident during 1997 and 1998.Immediately after the Asian crisis started in the summer of 1997, the dollar sold off from August through October after which it turned higher again(see Figure 4.2). The CRB Index did just the opposite. It bounced first (as thedollar dipped). By November of 1997 the dollar was rallying again; the CRBIndex, however, had started a serious decline. The dollar stayed firm fromNovember 1997 to August 1998. During these 10 months of dollar strength,the CRB tumbled to the lowest level in twenty years as fears of commodityprice deflation intensified. During 1997 and 1998, the gold market mirroreddollar moves almost perfectly. Gold hit an interim low during August 1997just as the dollar started another downside correction that lasted into October. When the dollar rebounded during the fourth quarter, gold resumed itsdowntrend. Nothing had changed in the intermarket relationship betweenthe dollar and commodities. During 1997 and 1998, the dollar rose while commodities fell.
20.0%
CRB IndexUS Dollar IndexGold - Continuous Contract
15.0%10.0%5.0%0.0%-5.0%-10.0%-15.0%-20.0%-25.0%© StockCharts.com 2003
D
F M A M J
FIGURE 4.2
J
A S O N D
F M A M J
J
-30.0%
A S O N D
Gold and the CRB Index trended inversely to the dollar during 1997 and 1998.
04_chap_murphy.qxd 10/31/03 12:53 PM Page 56
56
INTERMARKET ANALYSIS
30.0%
Industrial Metal Prices - Goldman Sachs Commodity IndexHong Kong Hang Seng
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
Feb
FIGURE 4.3
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
-30.0%
Dec
Industrial metals and the Hang Seng Index peaked together during thesummer of 1997.
HONG KONG AND INDUSTRIAL METALS PEAK TOGETHERIndustrial metal prices were hit especially hard. The collapse in Asian markets raised fears of an economic downturn in that part of the world, whichput a damper on all global economies. A comparison of industrial metalprices and Hong Kong’s Hang Seng Index shows a remarkably close correlation (see Figure 4.3). Both indexes peaked at the end of July 1997 and felltogether for at least another year. In the next chapter, we will see that arebound in the Hong Kong market near the start of 1999 contributed to anupturn in commodity markets that year.
COMMODITIES VERSUS BONDSThis intermarket relationship held up also during 1997 and 1998. After commodities peaked at the start of 1996, they maintained an almost perfect inversecorrelation with Treasury bond prices until the end of 1998, as shown in Figure4.4. The CRB peak in the spring of 1996 coincided with a bottom in bondprices. The early months of 1997 saw a downside correction in bond prices,
04_chap_murphy.qxd 10/31/03 12:53 PM Page 57
57
The 1997 Asian Currency Crisis and Deflation
15.0%
CRB Index30-Year US Treasury Bond Price
12.5%10.0%7.5%5.0%2.5%0.0%-2.5%-5.0%-7.5%-10.0%-12.5%-15.0%-17.5%-20.0%-22.5%© StockCharts.com 2003
Apr
FIGURE 4.4
Jul
Oct
Apr
Jul
Oct
Apr
Jul
-25.0%
Oct
The CRB Index and Treasury bond prices traded inversely from 1996through 1998.
which coincided with a rebound in the CRB Index. During the spring of thatyear, however, bonds began a major advance that lasted until the end of 1998.Commodities peaked within a month of the bond market bottom and fellthrough the remainder of the year. In October 1997 (three months after theAsian currency crisis started), bond prices soared to a new high for the yearwhile commodities tumbled. By the end of 1997, bond prices had touched arecord high, whereas the CRB Index had fallen to the lowest level in threeyears. These inverse trends continued through the balance of 1998. (We willsee in the next chapter that both of those trends reversed in 1999.) Both markets did exactly what they would normally be expected to do in the midst of adeflationary threat. Bond prices rose drastically while commodities fell drastically. Here again, nothing had changed in this key intermarket link. What didchange, though, was the relationship between bonds and stocks.
BONDS VERSUS STOCKSAfter 1994, bonds and stocks resumed their long-term bull markets. Duringthe first quarter of 1997, both markets experienced relatively modest down-
04_chap_murphy.qxd 10/31/03 12:53 PM Page 58
58
INTERMARKET ANALYSIS
30.0%
Dow Jones Industrial Average30-Year US Treasury Bond Price
27.5%25.0%22.5%20.0%17.5%15.0%12.5%10.0%7.5%5.0%2.5%0.0%-2.5%-5.0%-7.5%© StockCharts.com 2003
Dec
Feb Mar Apr
FIGURE 4.5
May
Jun
Jul
Aug
Sep
Oct
Nov Dec
-10.0%
Feb
Stocks and bonds started diverging after the Asian currency crisis in July 1997.
side corrections that lasted into April (see Figure 4.5). Both markets bottomed together that month and rose together through the end of July 1997—when the Asian currency crisis hit. Initially, bonds and stocks dippedtogether for a month or so before rebounding in September. In October, theirrelationship changed. Stocks fell sharply during that month. The Dow Industrials dropped over a thousand points, losing about 12 percent. At the sametime, however, bond prices rose; they continued to rise until January. Thebond rally ended at the start of 1998 just as stocks started to rally again. Inthe past, bonds and stocks had decoupled for short periods of time, especially in market crises like that of 1987. What few people could have suspected during the fourth quarter of 1997 was that this decoupling of bondsand stocks would last for at least another five years and would change one ofthe most important intermarket relationships. Things got even worse in 1998.
BONDS AND STOCKS DIVERGE IN 1998A comparison of bond and stock prices in 1998 shows dramatically divergenttrends (see Figure 4.6). Stocks rose from January through April, while bonds
04_chap_murphy.qxd 10/31/03 12:53 PM Page 59
59
The 1997 Asian Currency Crisis and Deflation
25.0%
Dow Jones Industrial Average30-Year US Treasury Bond Price
22.5%20.0%17.5%15.0%12.5%10.0%7.5%5.0%2.5%0.0%© StockCharts.com 2003
Dec
Feb Mar
FIGURE 4.6
Apr
May Jun
Jul
Aug Sep
Oct
Nov Dec
-2.5%
Feb
The decoupling of bonds and stocks became more obvious during 1998.
sold off. The stock market corrected that spring, but bond prices started torise. During June and early July, stocks made one more run to the upside;bonds pulled back. In the middle of July, stocks started to tumble. From itsJuly peak to its October bottom, the Dow dropped almost 2,000 points (about20 percent). During these three months, bond prices soared to a new recordhigh. Panic selling in global stock markets caused a massive asset allocationmove out of stocks into U.S. Treasury bonds. (Matters were made worsewhen a financial crisis in Russia during August 1998 crushed the ruble andraised fears of Russian debt defaults. The failure of a major hedge firm, LongTerm Capital Management, did not help either.) With some help from theFed, however, the stock market stabilized to form an October 1998 bottom.From the October bottom, the stock market turned higher and by the startof 1999 was trading at a new record high. Just as stocks were bottomingthroughout October, bond prices peaked and began a major decline thatlasted almost a year. For all of 1999, bond prices fell while stocks rose. Thebond-stock decoupling had now lasted for more than a year. This decouplingwould last for several more years and would confound those who failed torecognize that a major change had taken place in this key intermarket relationship. This change was being driven by fears of deflation emanating from
04_chap_murphy.qxd 10/31/03 12:53 PM Page 60
60
INTERMARKET ANALYSIS
Asia. The Japanese market was already in the grip of deflation. The Asian currency crisis that started in 1997 raised fears that Asian deflation was startingto spread elsewhere.
THE CRB/BOND RATIO AND SECTOR ROTATIONWe studied the CRB/bond ratio in the previous chapter and showed how itsdirection could influence sector rotation within the stock market. We knowthat a rising CRB/bond ratio favors inflation stocks; a falling ratio, however,favors interest rate-sensitive stocks. We are going to study the same ratio during the 1997–1998 period but with a couple of new wrinkles added. We aregoing to expand the notion of which sectors are affected by the CRB/bondratio. In addition, we are going to expand on the use of relative strength analysis, which is so crucial in sector work.
CONSUMER VERSUS CYCLICAL STOCKSTwo major sectors of the stock market that are always competing forinvestor funds are consumer and cyclical stocks. As their name implies, cyclicals are economically sensitive stocks that rise and fall with the businesscycle. They tend to do especially well when the economy is strong and badlywhen the economy is weak. Many of the stocks in this group are tied to commodities like aluminum, copper, and paper & forest products. As a result, thisgroup is closely tied to the fortunes of commodity prices. Consumer stocks,by contrast, include consumer staples like beverage, food, drug, tobacco, andpersonal products. These stocks hold relatively steady in good and bad economic times. When the economy is strong, cyclicals usually do better thanconsumer staples. When the economy is weak, consumer staples usually dobetter than cyclicals. This brings us back to the CRB/bond ratio. A risingratio favors economically sensitive cyclical stocks. A falling CRB/bond ratiofavors the more defensive consumer staples. These trends were clearly evident during 1997 and 1998.
CRB/BOND RATIO COLLAPSES DURING 1997Figure 4.7 shows that during the summer of 1997, the CRB/bond ratio startedto tumble (reflecting higher bond prices and lower commodities). It con-
04_chap_murphy.qxd 10/31/03 12:53 PM Page 61
61
The 1997 Asian Currency Crisis and Deflation
3.1
CRB Index / 30Y Bond Price Ratio
3.02.92.82.72.62.52.42.32.22.12.01.91.8© StockCharts.com 2003
A
J
O
FIGURE 4.7
A
J
O
1.7A
J
O
A
J
O
A
J
O
A
J
O
The CRB/bond ratio started tumbling during the second half of 1997.
tinued to tumble until the end of 1998. Bonds do better than commodities dueto fears of economic weakness. (Bonds do better than stocks due to the samefear.) By October 1997, the stock market had fallen sharply, which heightened fears of economic damage. At the same time, the CRB/bond ratio fell tothe lowest level in nearly two years. These trends caused a rotation out ofcyclicals and into consumer stocks that lasted until the end of 1998.
RELATIVE STRENGTH ANALYSISThe indexes that are used to measure these two market sectors are theMorgan Stanley Consumer Index (CMR) and the Morgan Stanley Cyclical Index (CYC). A visual comparison of these two indexes shows that consumerstocks rose from the middle of 1997 to the end of 1998, while cyclical stocksfell. A better way to compare their performance, however, is with ratio, or relative strength, analysis. Normally, when we measure the relative strength ofany market group (or stock), we do so against a stock market benchmark likethe S&P 500 Index. In this case, the Morgan Stanley Consumer and CyclicalIndexes are each divided by the S&P 500. These ratios are then compared. A
04_chap_murphy.qxd 10/31/03 12:53 PM Page 62
62
INTERMARKET ANALYSIS
0.485
Consumer / S&P 500 Ratio
0.4800.4750.4700.4650.4600.4550.4500.4450.4400.4350.4300.4250.4200.4150.410© StockCharts.com 2003
FM A M J J A S O