N D
FIGURE 4.8
0.405FM A M J J A S O N D
FM A M J
The Consumer/S&P 500 ratio rose during 1998, reflecting strength indefensive stocks.
0.56
Cyclicals / S&P 500 Ratio
0.540.520.500.480.460.440.420.400.38© StockCharts.com 2003
FM A M J J A S O N D
FIGURE 4.9
0.36F M A M J J A S O N D
FM A M J
The falling ratio during 1998 showed weak performance by economicallysensitive stocks.
04_chap_murphy.qxd 10/31/03 12:53 PM Page 63
63
The 1997 Asian Currency Crisis and Deflation
rising ratio means that the market sector is outperforming the S&P 500, whichis a sign of relative strength. A falling ratio is a sign of relative weakness.The Consumer/S&P 500 ratio bottomed during October 1997 and rose untilOctober 1998, as shown in Figure 4.8. The Cyclical/S&P 500 ratio peaked during October 1997 and plunged until the end of 1998 (see Figure 4.9). From thefourth quarter of 1997 to the fourth quarter of 1998, the ratio charts made itclear that the defensive consumer stocks were the place to be; the more economically sensitive cyclical stocks were not. This superior performance ofconsumer stocks over cyclical stocks continued until the CRB/bond ratioturned up at the start of 1999.
PLOTTING A RATIO OF TWO COMPETING SECTORSA second way to compare two market sectors is to divide one by the other.When an investor is faced with two competing assets, it is usually better togo with the stronger of the two. A ratio that divides the Consumer Index bythe Cyclical Index in 1997 and 1998 shows a dramatic upturn in October 1997that lasted until the end of 1998 (see Figure 4.10). Investors would have done
1.20
Consumer / Cyclicals Ratio
1.151.101.051.000.950.900.850.80© StockCharts.com 2003
FM A M J J A S O N D
FIGURE 4.10
F M A M J J A S O N D
FM A M J
The rising ratio showed stronger performance in defensive stocksduring 1998.
0.75
04_chap_murphy.qxd 10/31/03 12:53 PM Page 64
64
INTERMARKET ANALYSIS
much better by concentrating on consumer stocks and avoiding cyclicals.They could have come to this conclusion by plotting the CRB/bond ratio. Bythe start of 1999, the CRB/bond ratio started to turn higher. At the same time,money flowed out of consumer stocks and back into the more commodityrelated cyclicals. As a rule of thumb, consumer staples are closely tied tobond prices; cyclical stocks are closely tied to commodity prices.
INTERMARKET LESSONS OF 1997 AND 1998Much was learned about intermarket relationships during the years of 1997and 1998. Those two years demonstrated the need to monitor global markets—not just in stocks, but in currencies as well. The collapse in a relativelyobscure Asian currency started a ripple effect that eventually had a dramaticimpact on the U.S. bond and stock markets. The most obvious impact was aflight out of stocks and into bonds that lasted for 18 months. Within the stockmarket, sector rotation trends were influenced. Funds rotated into moredefensive consumer staples at the expense of economically sensitive cyclicalstocks. Another effect of the Asian contagion was the collapse in commoditymarkets, which intensified fears of global deflation.Perhaps the most important lesson of all was that deflationary trendscoming from Asia caused a major change in the relationship between bondsand stocks. Rising bond prices no longer helped stock prices. Instead, a rising bond market came at the expense of stocks. This change would becomeeven more pronounced during the major bear market in stocks that started acouple of years later. In the next chapter, we will see that 1999 reversedmany of the trends of 1998. Although these intermarket trend reversals in1999 helped stocks initially, they also contributed to the bursting of the stockmarket bubble in 2000.
05_chap_murphy.qxd 10/31/03 12:56 PM Page 65
CHAPTER 5
1999 IntermarketTrends Leadingto Market Top
1999 SEES REVERSAL OF 1998 TRENDSThe global deflation fear that gripped the financial markets in 1998 causeda flight out of commodities and stocks and into the bond market. Figure 5.1shows the decoupling of bonds and stocks that took place in 1998 because of
115.0114.0
S&P 500 Large Cap Index30-Year US Treasury Bond Price
1250.0
DEFLATIONSCARE!
113.0
1225.01200.0
112.0111.0
1175.0
110.0
1150.0
109.0
1125.0
108.0
1100.0
107.0
1075.0
106.0
1050.0
105.0
1025.0
104.0
1000.0
103.0
975.0
102.0
950.0
101.0100.0
© StockCharts.com 2003
Jun
FIGURE 5.1
Jul
Aug
Sep
Oct
Nov
925.0
Dec
Shows decoupling of bonds and stocks during 1998.
65
05_chap_murphy.qxd 10/31/03 12:56 PM Page 66
66
116.0
INTERMARKET ANALYSIS
© StockCharts.com 2003
S&P 500 Large Cap Index30-Year US Treasury Bond Price
1450.0
114.0
1400.0
112.0
1350.0
110.0
1300.0
108.0
1250.0
106.0
1200.0
104.0
1150.0
102.0
1100.0
100.01050.0
98.0
1000.0
96.0
950.0
94.0Sep
FIGURE 5.2
Oct
Nov
Dec
Feb
Mar
Apr
May
Jun
Jul
Aug
During 1999, stocks rose while bonds fell.
this deflation threat. In 1999, these trends were reversed. The stock marketsoared to a new record high while bond prices suffered one of their worstyears in history (see Figure 5.2). Part of the reason for the fall in bond priceswas a sharp rise in the price of oil at the start of 1999, which pushed interestrates higher around the globe as inflation fears resurfaced. A recovery in Asianstock markets also contributed to global demand for industrial commoditieslike aluminum and copper. The rise in commodity prices prompted the Federal Reserve to start raising interest rates in the middle of the year, a movewhich contributed to a major top in the stock market the following year.Initially, the negative impact of rising interest rates was seen in twoplaces. One was in the deterioration in market breadth measures like theNYSE Advance–Decline line, which fell throughout the entire year. The otherwas in the area of sector rotation. Rising interest rates in 1999 had an especially negative impact on those stock market groups that are considered to berate sensitive. At the same time, inflationary stock groups had a relativelygood year. The market trends in 1999 also demonstrated the increasinglyprominent role of global influences in intermarket work. A collapse in Asianmarkets had pushed commodity prices sharply lower throughout 1997 and
05_chap_murphy.qxd 10/31/03 12:56 PM Page 67
1999 Intermarket Trends Leading to Market Top
67
1998. A rebound in these same markets in 1999 pushed commodity priceshigher and resulted in heavy losses in global bond markets. While the rotation out of bonds helped stocks initially in 1999, the longer-lasting effectswere more damaging. Our discussion of intermarket trends in 1999 approachesthe subject on three levels. The first is the macro relationships between commodities, bonds, and stocks. The second is the impact that these macro intermarket forces had on sector rotations within the stock market. The thirddeals with global influences.
COMMODITIES JUMP AT START OF 1999The direction of commodity prices in 1999 played a key role in the directionof interest rates. It was no coincidence that 1999 saw the biggest upturn incommodity prices in years and one of the biggest downturns in bond prices.As a result of rising commodity prices, the Fed started raising rates that summer. This action had a subtle but negative effect on the stock market, particularly on old economy stocks that are traditionally more affected by interestrate direction. New economy technology stocks proved relatively immune torising rates in 1999—but not in 2000.
COMMODITIES AND RATES TREND TOGETHERA comparison of commodity prices to the yield on the 10-year Treasury note(which has become the new benchmark for long-term U.S. Treasury rates)shows that they generally trend in the same direction. (Commodity pricesmove in the opposite direction of bond prices but in the same direction asbond yields.) In 1997 and 1998, as deflation fears surfaced, interest rates andcommodity prices fell together. By the start of 1999, however, both were rising again. Bond yields actually troughed in October 1998 as the stock marketbottomed and bond prices peaked. This move reflected a massive asset allocation switch out of bonds and back into stocks which lasted through the following year. Commodity prices started moving up at the start of 1999.Throughout the balance of that year, commodity prices and bond yields rosetogether. Figure 5.3 shows the Goldman Sachs Commodity Index and Treasury Bond yields breaking down trendlines at the start of 1999 as they bottomed together.
05_chap_murphy.qxd 10/31/03 12:56 PM Page 68
68
INTERMARKET ANALYSIS
Total Return - Goldman Sachs Commodity Index
3750.03500.03250.03000.0
RISING COMMODITY PRICES
2750.02500.02250.02000.0
30-Year T-Bond Yield
65.0RISING BOND YIELDS
60.055.050.0
© StockCharts.com 2003
J
A S O N D
FIGURE 5.3
F M A M J
J A S O N D
F M A M J
J
A
The GSCI and bond yields bottomed together at the start of 1999.
INDUSTRIAL COMMODITIES AND OIL BOTTOMTwo of the commodity groups that turned up first at the start of 1999 were oiland industrial metals. Because of its heavy weighting in crude oil (whichtripled in price that year), the Goldman Sachs Commodity Index was amongthe first of the commodity indexes to turn up. Figure 5.4 shows the GSCI rising above its 200-day moving average during March 1999, which was a signthat its major trend had turned up again.Industrial commodity prices also turned up as shown in Figure 5.5. TheGoldman Sachs Industrial Metals Index broke a resistance line during the firstquarter of 1999 and rallied sharply thereafter. (The rebound in industrialmetals was the result of a rebound in the Pacific Rim.) The upturn in the CRBIndex was delayed by weak agricultural markets during the first half of 1999.With two of the most interest-sensitive commodity groups rising together in1999—oil and industrial metals—it was no surprise to see a correspondingrise in short- and long-term interest rates.
05_chap_murphy.qxd 10/31/03 12:56 PM Page 69
69
1999 Intermarket Trends Leading to Market Top
Total Return - Goldman Sachs Commodity IndexMoving Average (200 days)
2900.02800.02700.02600.02500.02400.02300.02200.02100.02000.01900.0
© StockCharts.com 2003
Apr May Jun
Jul Aug Sep Oct Nov Dec
Feb Mar
Apr May Jun
FIGURE 5.4
The GSCI rose about its 200-day average during March 1999.
Jul Aug
Industrial Metal Prices - Goldman Sachs Commodity Index
157.5155.0152.5150.0147.5145.0142.5140.0137.5135.0132.5130.0127.5
© StockCharts.com 2003
F
M
FIGURE 5.5
A
M
J
125.0J
A
S
O
N
D
F
M
A
M
J
J
A
Industrial Metals broke a resistance line during the first quarter of 1999.
05_chap_murphy.qxd 10/31/03 12:56 PM Page 70
70
INTERMARKET ANALYSIS
THE IMPACT OF RISING RATES ON STOCKSRising interest rates usually have a negative influence on the stock market.This negative influence on the U.S. stock market was present in 1999, but ina subtle way. Although new economy technology stocks in the Nasdaq market rose sharply during the second half of 1999, old economy stocks (on theNew York Stock Exchange) stopped rising right around the time that the Fedstarted tightening in the middle of the year. The New York Stock Exchange(NYSE) Composite Index peaked during July 1999 (just as the Fed startedto raise short-term rates) and declined for the rest of that year. Although itretested its highs a year later, the summer of 1999 marked the beginning ofthe topping process in the NYSE Composite Index.
NYSE ADVANCE-DECLINE LINE FALLS IN 1999A more dramatic demonstration of the impact of rising interest rates in 1999was seen in the deterioration in the NYSE Advance-Decline line. (The AD linemeasures the difference between the number of advancing stocks and declining stocks on the NYSE. A falling line means that more stocks are decliningthan advancing, which is sign of stock market weakness.) The AD line actually peaked in 1998 and continued to fall throughout 1999. The NYSE AD linehas a history of peaking ahead of the major stock market averages and is considered to be a leading indicator for the rest of the market. Historically, therehas usually been a fairly close correlation between bond prices and the ADline. Over a third of the NYSE stocks are considered to be rate-sensitive andare usually the first to peak in a climate of rising rates. They in turn have adepressing effect on the NYSE AD line (see Figure 5.6).The fall in the NYSE AD line in 1999 suggests that the broader stock market was more adversely affected by rising rates that most people realized. Italso contradicted the view put forward by some market observers (especiallyin the media) that the stock market was largely unaffected by rising interestrates. This stock market deterioration in 1999 was masked by continuingstrength in an increasingly smaller portion of the stock market that was concentrated in the Nasdaq market. In time, rising rates would take a toll thereas well. On a macro intermarket level, 1999 saw a combination of risingcommodity prices and rising interest rates, which has traditionally been anegative omen for stocks. Another sign of danger for the stock market wasseen in the impact of rising commodity prices (mainly in oil) on various sectors within the stock market.
05_chap_murphy.qxd 10/31/03 12:56 PM Page 71
71
1999 Intermarket Trends Leading to Market Top
700.0%
NYSE Advancing-Declining Issues
600.0%500.0%400.0%300.0%200.0%100.0%0.0%-100.0%© StockCharts.com 2003
Apr Jul Oct
FIGURE 5.6
-200.0%Apr Jul Oct
Apr Jul Oct
Apr Jul Oct
Apr Jul
The NYSE AD line peaked in the spring of 1998.
INTERMARKET SECTOR EFFECTAlthough intermarket trends say a lot about the direction of inflation andinterest rates (and can have an important influence on asset allocation strategies), one of their most practical applications is in the area of sector andindustry group rotation within the stock market. Group rotation refers tomoney flows from one stock market group to another. (There are 10 stockmarket sectors. Each sector is subdivided into industry groups. There aremany more industry groups than sectors. The term sector rotation generallyincludes movements among sectors and industry groups.)
RISING CRUDE WAS GOOD FOR OIL SHARESCrude oil prices tripled in 1999. Rising oil benefits some stock groups, buthurts others. The most obvious beneficiaries of higher oil prices are oil shares.It should come as no surprise, then, to find out that oil shares were the strongestpart of the stock market in 1999. Figure 5.7 compares the AMEX Oil Index
05_chap_murphy.qxd 10/31/03 12:56 PM Page 72
72
0.46
INTERMARKET ANALYSIS
Oil Index - AmexOil / S&P 500 Ratio
540.0
0.44
520.0
0.42
500.0
0.40
480.0
0.38
460.0440.0
0.36
420.0
0.34
400.00.32© StockCharts.com 2003
Aug
Sep
FIGURE 5.7
Oct
Nov Dec
Feb Mar
Apr
May
Jun
Jul
380.0
Aug
Oil stocks and the XOI/S&P ratio turned up near the start of 1999.
(XOI) to a ratio of the XOI divided by the S&P 500. Both turned up near thestart of 1999, indicating that oil shares were moving up on both an absoluteand a relative basis. (There is, however, a warning in that.) The upturn inenergy shares near the start of 1999 also confirmed the chartists’ suspicionthat oil prices were indeed headed higher, as there is usually a positive correlation between the direction of oil prices and oil shares. While oil shares benefited from rising oil prices, other groups suffered as a result.
TRANSPORTATION STOCKS FALL HARDTransportation stocks (and airlines in particular) are especially sensitive tothe direction of crude oil prices. So much of transportation companies’ operating expenses are dependent on the cost of fuel. Within a couple of monthsof the upturn in oil prices at the start of 1999, transportation stocks started amajor decline that lasted into the following spring. During this period, transports lost 40 percent of their value. Transportation stocks were not the onlystock group hurt by rising oil prices in 1999. As rising oil prices led to rising
05_chap_murphy.qxd 10/31/03 12:56 PM Page 73
73
1999 Intermarket Trends Leading to Market Top
interest rates, the market groups that are most sensitive to the direction ofinterest rates began to suffer—especially financial stocks.
FINANCIAL STOCKS LOSE FAVOR DURING 1999We discussed the concept of ratio analysis and how it is used to measure therelative strength of a market group. (The group index is usually divided by amarket benchmark like the S&P 500.) This technique was especially useful in1999. Ratio analysis showed that oil stocks outperformed the S&P 500 thatyear, whereas transportation stocks underperformed. (It is always better tobe in the group that is outperforming the S&P 500.) The ratio analysis technique showed that financial stocks were one of the year’s weakest groups. Aratio of financial stocks divided by the S&P 500 shows that group underperforming the market all year (see Figure 5.8). This is consistent with theintermarket principle that financial stocks do not do well in a climate ofrising interest rates. The falling relative strength ratio demonstrated howbadly financial stocks did in 1999 relative to the rest of the market.
0.275
SP 500 Financials / S&P 500 Ratio
0.2700.2650.2600.2550.2500.2450.2400.2350.2300.2250.2200.2150.210© StockCharts.com 2003
Feb
Mar
FIGURE 5.8
Apr
0.205May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Financial stocks underperformed the S&P 500 during 1999 asinterest rates rose.
05_chap_murphy.qxd 10/31/03 12:56 PM Page 74
74
INTERMARKET ANALYSIS
This poor performance by rate-sensitive stocks in 1999 also confirmedthe trend toward higher commodity prices and higher U.S. interest rates. Theprior examples illustrate the importance of being in tune with intermarkettrends from a sector rotation standpoint. They show that in a climate of rising oil prices and rising interest rates, oil stocks are generally a good place tobe, while financial and transportation stocks are not. Although these examples may seem fairly obvious, there are more subtle intermarket principlesthat play on stock market groups.
OTHER SECTOR INFLUENCESI explained that during a period of rising industrial commodity prices, basicmaterial stocks (like aluminum and copper) usually do relatively well. Atthe same time, consumer staples usually do worse. Recall that in addition, arising commodity/bond ratio favors inflation-type stocks. A rising commodity/bond ratio hurts rate-sensitive stock groups like banks, brokers, and consumer staples (including drugs). These trends were clearly evident in 1999.The commodity/bond ratio turned up. Figure 5.9 plots a ratio of the GSCI
GSCI Spot Index / 30Y Bond Price Ratio
2.52.42.32.22.12.01.91.81.71.61.51.41.31.2
© StockCharts.com 2003
Apr
FIGURE 5.9
Jul
Oct
Apr
Jul
Oct
The commodity/bond ratio bottomed at the start of 1999.
Apr
Jul
05_chap_murphy.qxd 10/31/03 12:56 PM Page 75
75
1999 Intermarket Trends Leading to Market Top
divided by Treasury Bond prices. The commodity/bond ratio bottomed at thestart of 1999. Its major down trendline was broken a few months later, whichconfirmed the important upside reversal.Starting in the spring of 1999, economically sensitive cyclical stockssurged just as commodity prices started to rise (although the rise in cyclicalshares was fairly dramatic, it proved to be relatively short-lived). Figure 5.10plots two lines. The top line shows the Morgan Stanley Cyclical Index breaking a down trendline in April 1999. The lower line is a ratio of that indexdivided by the S&P 500. The ratio turned up as well that spring, meaning thatcyclical shares were leading the market higher. At the same time, bank stocksturned down and continued falling through the balance of that year. Figure5.11 plots a ratio of the Philadelphia Stock Exchange (PHLX) Bank Index(BKX) divided by the S&P 500. The falling ratio line shows the relative weakness of bank shares in 1999, and is reflective of the poor performance in thefinancial sector.As cyclical stocks surged during April of that year, consumer staples lostfavor. As part of the latter group, drug stocks fell both on an absolute and arelative basis. Figure 5.12 is a ratio of the AMEX Pharmaceutical Index(DRG) divided by the S&P 500 and shows a sharp drop during April. Duringthat month, money going into the more inflation-sensitive cyclical shares
Cyclicals Index - Morgan Stanley
650.0600.0550.0500.0450.0400.0
Cyclicals / S&P 500 Ratio
0.550.500.450.40© StockCharts.com 2003
A S
O N D
FIGURE 5.10
F M
A M J
J A
S O N D
F M
A M J
J A
S
Both lines turned up in the spring of 1999, reflecting strong cyclical stocks.
05_chap_murphy.qxd 10/31/03 12:56 PM Page 76
76
INTERMARKET ANALYSIS
0.725
Banks / S&P 500 Ratio
0.7000.6750.6500.6250.6000.5750.5500.5250.500© StockCharts.com 2003
Feb
Mar
FIGURE 5.11
Apr
0.475May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Money rotated out of bank stocks in April 1999.
0.335
Pharmaceutical / S&P 500 Ratio
0.3300.3250.3200.3150.3100.3050.3000.2950.2900.2850.2800.2750.2700.265© StockCharts.com 2003
Aug
Sep
Oct
FIGURE 5.12
Nov
Dec
Feb
Mar
Apr
May
Drug stocks fell out of favor during April 1999.
Jun
Jul
Aug
05_chap_murphy.qxd 10/31/03 12:56 PM Page 77
1999 Intermarket Trends Leading to Market Top
77
rotated out of the more rate-sensitive stocks of banks and drugs (and consumer staples). The main reason for this rotation was that commodity priceswere going up and bond prices were going down. (In Chapter 7, when weexamine the bursting of the Nasdaq bubble in the spring of 2000, we will seea massive rotation back into these very same “defensive” groups like consumer staples, drugs, financials, and Treasury bonds.)
SECTOR ROTATION AND THE ECONOMYDifferent market sectors do better at different stages of the business cycle.Near the end of an economic expansion, for example, energy stocks usuallytake over market leadership. This is primarily due to rising energy prices andthe resulting buildup of inflation pressures. As happened in 1999, a risinginflation threat prompts the Federal Reserve to raise short-term interestrates. In time, rising rates have the effect of slowing the economy. This usually leads to an economic slowdown, which often turns into a recession. Thesurge in oil prices at the start of 1999 and the resulting jump in interest ratesthat year started in motion a series of events which led to a major market topone year later and a recession a year after that.The stock market peaks in stages. Interest rate-sensitive stocks usuallypeak first owing to rising interest rates. Many of them started peaking in 1998.Energy stocks usually peak last. (Oil service stocks did not peak until 2000.)This usually signals the end of an economic expansion and the beginning of aneconomic contraction. One way to tell when the economy has crossed thethreshold from late expansion to early contraction is when leadershipswitches from energy stocks to more defensive stock groups like consumerstaples. This is exactly what happened in 2000. Later in the book, we willexamine sector rotation within the business cycle in more depth. I introduceit here to explain why the surge in oil prices and oil shares in 1999 (and theresultant Fed tightening) were classic signs of a major market top in the making and the start of serious economic problems. These signs became evenmore obvious at the start of 2000.
GLOBAL INFLUENCES IN 1999The last piece of the intermarket trilogy in 1999 has to do with global influences. The previous chapter showed the close correlation between a fallingHong Kong stock market in the middle of 1997 and the bearish effect that it had
05_chap_murphy.qxd 10/31/03 12:56 PM Page 78
78
INTERMARKET ANALYSIS
Total Return - Goldman Sachs Commodity IndexHong Kong Hang Seng
17000.0
3800.03600.0
16000.015000.0
GLOBAL DEFLATION?
GLOBAL INFLATION?
3400.0
14000.0
3200.0
13000.0
3000.0
12000.0
2800.0
11000.0
2600