since then, with special emphasis on the events of the1980s. Toward the end of the book, a glance backward a bit further will reveal a largerhistorical perspective.FINANCIAL MARKETS ON THE DEFENSIVEAs Chapter 3 suggested, the 1970s were a period of rising inflation and rising interestrates. It was the decade for tangible assets. Bond prices had been dropping sharplysince 1977 and continued to do so until 1981. The weight of rising commodity priceskept downward pressure on bond prices as the 1970s ended. During that decade, bondmarket troughs in 1970 and 1974 preceded trading bottoms in the equity markets. Abond market top in 1977, however, pushed stock prices lower that year and kept thestock market relatively dormant through the end of the decade. In 1980 a major top inthe commodity prices set the stage for a significant bullish turnaround in bond pricesin 1981. This bullish turnaround in bonds set the stage for the major bull market instocks that started in 1982.To put things in proper perspective, the period from 1977 to 1980 was alsocharacterized by a falling U.S. dollar, which boosted inflation pressures and keptdownward pressure on the bond market. The U.S. dollar bottomed out in 1980, which
The comparison of bonds and stocks will begin with the events surrounding the 1981bottom in bonds and the 1982 bottom in stocks. Then a gradual analysis through thesimultaneous bull markets in both sectors culminating in the events of 1987 and 1989will be given. Figures 4.1 and 4.2 are monthly charts of Treasury bonds and the Dow
FIGURE 4.1MONTHLY CHART OF TREASURY BOND FUTURES FROM 1978 THROUGH SEPTEMBER 1989.THE INDICATOR ALONG THE BOTTOM IS A 14 BAR SLOW STOCHASTIC OSCILLATOR. AMONTHLY CHART IS HELPFUL IN IDENTIFYING MAJOR TURNING POINTS. TURNS IN THEBOND MARKET USUALLY PRECEDE SIMILAR TURNS IN THE STOCK MARKET. THE BOTTOM INBONDS IN 1981 GAVE AN EARLY WARNING OF THE MAJOR BULL MARKET THAT BEGAN INSTOCKS THE FOLLOWING YEAR. (SOURCE : COMMODITY TREND SERVICE, P.O. BOX 32309,PALM BEACH GARDENS, FLORIDA 33420.)T-Bonds Monthly
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FIGURE 4.2MONTHLY CHART OF THE DOW JONES INDUSTRIAL AVERAGE FROM 1971 THROUGH SEPTEMBER 1989. THE INDICATOR ALONG THE BOTTOM IS A 14 BAR SLOW STOCHASTIC OSCILLATOR. MAJOR TRENDS IN THE STOCK MARKET USUALLY FOLLOW SIMILAR TURNS IN BONDS.THE STOCK MARKET BOTTOM IN 1982 AND THE PEAK IN 1987 WERE PRECEDED BY SIMILARTURNS IN BONDS BY ELEVEN AND FOUR MONTHS, RESPECTIVELY. (SOURCE : COMMODITYTREND SERVICE, P.O. BOX 32309, PALM BEACH GARDENS, FLORIDA 33420.)Dow Jones Industrials-Monthly
BONDS AS A LEADING INDICATOR OF STOCKS
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The bullish turnaround began in 1981. In September of that year, bonds hit theirlowpoint and began a basing process that culminated in an important bullish breakoutin August 1982. From September of 1981 to August of 1982, the bonds formed apattern of three rising bottoms. Those three rising bottoms in bonds coincide withthree declining bottoms in stocks. A major positive divergence was in place. As stockscontinued to drop, the lack of downside confirmation by the bond market providedan early warning that a significant turn might be in progress.August 1982 stands out as a milestone in stock market history. During that month,while many stock market traders were relaxing at the seashore, the great bull marketof the 1980s began. During that month, the Dow Industrials dropped to a two-yearlow before recovering enough to register a bullish monthly reversal. At the same timebonds were breaking out from the basing pattern that had been forming for a year.After diverging from stocks for a year, the bullish breakout in bonds confirmed thatsomething important was happening on the upside.In Figures 4.1 and 4.2, notice the action of the stochastics oscillator during thebottoming process. The dotted line in the stochastics oscillator on the bond chartcrossed above the solid line in the fall of 1981 from a level below 25, providing abuy signal in bonds. A similar buy signal in stocks didn't occur until the summer of1982. The technical action in bonds preceded the bottom in stocks by almost a year.It should seem clear that stock market traders would have benefited from a technicalanalysis of bonds during that historic turnaround.BONDS AS A LEADING INDICATOR OF STOCKS
Industrials with a monthly stochastics oscillator along the bottom of each. These arethe same types of charts that were used in Chapter 3 in comparing bond activity tothe CRB Index, except in this case the comparison is of bonds to stocks. Instead oflooking for signals in the opposite direction as was done with bonds and the CRBIndex, the analyst will be looking for buy and sell signals in both bonds and stocksto be in the same direction.As the charts show, the period from 1977 to 1981 saw a falling bond marketand a relatively flat stock market. From 1977 to early 1980 the downward pull of thebond market kept stocks in a relatively narrow trading range. In early 1980 a sharpbond rally began in March which helped launch a stock market rally the followingmonth. The bond rally proved short-lived as prices began to drop again into 1981.After testing the upper end of its 14-year trading range, the Dow Industrials sold offagain into 1982.
The purpose of this chapter is twofold. One is to demonstrate a strong positive relationship between bonds and stocks. In other words, the price action and technicalreadings in the two markets should confirm each other. As long as they are moving inthe same direction, analysts can say that the two markets are confirming each otherand their trends are likely to continue. It's when the two markets begin to trend inopposite directions that analysts should begin to worry.The second point is that the bond market usually turns first. Near market tops,the bond market will usually turn down first. At market bottoms, the bond marketwill usually turn up first. Therefore, the technical action of the bond market becomesa leading technical indicator for the stock market.The young bull market in bonds and stocks continued into early 1983. In Mayof 1983, however, the bond market suffered a bearish monthly reversal, setting upa potential double top on the bond chart (see Figure 4.1). At the same time, thestochastics oscillator gave a sell signal. As Figure 4.2 shows, stocks began to roll overtoward the end of 1983 and flashed a stochastics sell signal as the year ended. Thesetback in stocks wasn't nearly as severe as that in bonds. However, the weaknessin bonds warned that it was time to take some profits prior to the 15 percent stockmarket decline.In mid-1984 both markets flashed new stochastics buy signals at about the sametime. (Bonds actually began to rally a month before stocks.) The beginning of thesecond bull leg in the bond market had a lot to do with resumption of the bullmarket in stocks. Both markets rallied together for another two years. It wasn't untilearly 1987, when the two markets began to move in opposite directions, that anothernegative divergence was given.hi April 1987 bonds began to drop (flashing a stochastics sell signal), which setthe stage for the 1987 stock market crash in October of that year. Once again the bondmarket had proven its worth as a leading indicator of stocks. The bullish monthly
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reversal in bonds in October 1987 also set the stage for the stock market recoveryfrom the 1987 bottom. A stochastics buy signal in bonds at the end of 1987 precededa similar buy signal in stocks by almost a year. During the entire decade of the 1980s,every significant turn in the stock market was either accompanied by or preceded bya similar turn in the bond market.Overlay charts will show comparison of the relative action of bonds and stocksover shorter time periods. On the monthly charts used in preceding paragraphs, pricebreakouts and stochastics buy and sell signals were emphasized. In the overlay charts,attention will shift to relative price action. Price divergences are easier to spot onoverlay charts, and the leads and lags between the two markets are more obvious.Figure 4.3 compares the two markets from 1982 through the third quarter of 1989.The similar trend characteristics of the two markets are more easily seen. The mostprominent points of interest on this chart are the simultaneous rallies in 1982; thebreakdown in bonds in 1983 leading to a stock market correction; the simultaneous
FIGURE 4.3A COMPARISON OF TREASURY BONDS AND STOCKS FROM 1982 TO 1989. ALTHOUGH BOTHMARKETS GENERALLY TREND IN THE SAME DIRECTION, BONDS HAVE A TENDENCY TO TURNAHEAD OF STOCKS. BONDS SHOULD BE VIEWED AS A LEADING INDICATOR FOR STOCKS.Treasury Bond Prices versus the Dow Industrials1982 through 1989
BONDS AS A LEADING INDICATOR OF STOCKS
45
upturn in both markets in 1984; the top in bonds in early 1987, preceding the stockmarket crash of 1987; and both markets rallying together into 1989. To the upper rightit can be seen that the breakout by stocks above their 1987 pre-crash highs has notbeen confirmed by a similar bullish breakout in bonds.Figures 4.4 through 4.9 break the period from 1982 to 1989 into shorter timeintervals to provide closer visual comparisons. I'll take a closer look at the eventsimmediately preceding and following the October 1987 stock market crash and willalso examine the market events of 1989 in more detail. Figure 4.4 shows the relativeaction of bonds and stocks at the 1982 major bottom. Notice that as the Dow Industrials hit succeeding lows in March, June, and August of 1982, the bond market wasforming rising troughs in the same three months. In August, although both marketsrallied together, bonds were the clear leader on the upside.In May of 1983, bonds formed a prominent double top and began to drop. Thatbearish divergence led to an intermediate stock market peak at the end of the year,which led to a 15 percent downward correction in the equity market. The downwardcorrection in both markets continued into the summer of 1984 (see Figure 4.5). AFIGURE 4.4A COMPARISON OF BONDS AND STOCKS DURING 1982 AND 1983. BONDS TURNED UPPRIOR TO STOCKS IN 1982 AND CORRECTED DOWNWARD FIRST DURING 1983.Bonds versus Stocks1982 and 1983
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FIGURE 4.5BONDS VERSUS STOCKS DURING 1984 AND 1985. BONDS TURNED UP A MONTH BEFORESTOCKS IN 1984. DURING 1985 TWO DOWNWARD CORRECTIONS IN TREASURY BONDSWARNED OF SIMILAR CORRECTIONS IN EQUITIES.Bonds versus Stocks1984 and 1985
close inspection of Figure 4.5 will show that the mid-1984 upturn in bonds precededstocks by almost a month. Both entities then rallied together through the end of 1985.Notice, however, that short-term tops in bonds in the first quarter and summer of 1985preceded downward corrections in the stock market.Figure 4.6 compares the two markets during 1986 and 1987. After rising foralmost four years, both markets spent 1986 in a consolidation phase. However, at thebeginning of 1987, stocks resumed their bull trend. As the chart shows, bonds didnot confirm the bullish breakout in stocks. What was even more alarming was thebearish breakdown in bonds in April of 1987 (influenced by a sharp drop in the U.S.dollar and a bullish breakout in the commodity markets). Stocks dipped briefly duringthe bond selloff. During June the bond market bounced a bit, and stocks resumed theuptrend. However, bonds broke down again in July and August as stocks rallied. You'llnotice that bonds broke support at the May lows in August, thereby flashing anotherbear signal. This bear signal in bonds during August 1987 coincided with the 1987peak in stocks the same month.
BONDS AS A LEADING INDICATOR OF STOCKS
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FIGURE 4.6BONDS VERSUS STOCKS DURING 1986 AND 1987. BONDS COLLAPSED IN APRIL OF 1987AND PRECEDED THE AUGUST PEAK IN STOCKS BY FOUR MONTHS.Bonds versus Stocks1986 and 1987
Bonds not only led stocks on the downside in the fall of 1987, they also ledstocks on the upside. Figure 4.7 shows the precipitous slide in bond prices whichpreceded the stock market crash in October 1987. The bearish breakdown in bondswas too serious to be ignored by stock market technicians. However, as the actualstock market crash began, the bond market soared in a flight to quality. Funds pulledout of the stock market in panic were quickly funneled into the relative safety ofTreasury bills and Treasury bonds. There was another important factor that helpsexplain the sharp rally in interest rate futures in October 1987.In the ensuing panic during the stock market crash, the Federal Reserve floodedthe financial system with liquidity in an attempt to calm the markets and cushion the stock market fall. At the time the consensus view was that a serious recession was at hand. As a result the sudden monetary easing pushed interest ratessharply lower. The lowering of interest rate yields pushed up the prices of interest ratefutures.At such times the normal positive relationship of bonds and stocks is temporarily disturbed. Until the markets stabilized, an inverse relationship between the two
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BONDS AS A LEADING INDICATOR OF STOCKS
49
FIGURE 4.7BONDS VERSUS STOCKS DURING THE LATTER HALF OF 1987 THROUGH THE SUMMER OF1988. THE STRONG REBOUND IN BONDS THAT BEGAN IN OCTOBER OF 1987 HELPED STABILIZE THE STOCK MARKET FOLLOWING THE 1987 CRASH.
FIGURE 4.8BONDS AND STOCKS ARE SHOWN RALLYING TOGETHER FROM 1988 THROUGH THE FOURTHQUARTER OF 1989. THE BULLISH BREAKOUT BY BONDS IN THE SPRING OF 1989 GAVE THESTOCK RALLY A BOOST.
Bonds versus Stocks1987 and 1988
Bonds versus Stocks1988 and 1989
sectors was evident. However, as Figure 4.7 shows, that inverse relationship was shortlived. In fact, it's remarkable how quickly the positive relationship was resumed.Within a matter of days, the peaks and troughs in bonds and stocks begin to move inthe same direction. However, the sharp rally in bonds into the first quarter of 1988reflected continued concerns about an impending recession (or depression) and thedesire on the part of the Federal Reserve Board to lower interest rates to prevent suchan eventuality.By the middle of 1988, things seemed pretty much back to normal. However,through it all, on the downside first and then on the upside, important directionalclues about stock market direction during the summer and fall of 1987 could bediscovered by monitoring the bond market.Figure 4.8 gives us a view of 1988 and the first three quarters of 1989. It can beseen that from the spring of 1988 to the fall of 1989, the peaks and troughs in bothsectors were closely correlated and that both markets rallied together. However, in
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FIGURE 4.9A COMPARISON OF BONDS AND STOCKS FROM OCTOBER 1988 TO SEPTEMBER 1989. THEVERTICAL LINES SHOW THE SIMILARITIES BETWEEN THE CORRESPONDING PEAKS ANDTROUGHS. DURING SEPTEMBER OF 1989, THE RALLY TO NEW HIGHS BY STOCKS HAS NOTBEEN CONFIRMED BY THE BOND MARKET, WHICH IS BEGINNING TO WEAKEN.Dow Jones Industrial AverageOctober 1988 to September 1989
WHAT ABOUT LONG LEAD TIMES?
51
this instance the stock market proved to be the stronger of the two. Although bothmarkets moved in the same direction, it wasn't until May of 1989 that bonds finallybroke out to the upside to confirm the stock market advance.Figure 4.9 gives a closer look at 1989. This chart shows the close visual correlationof both markets. The timing of the peaks and troughs is extremely close together.To the upper right, however, the bond market is beginning to show some signs ofweakness in what could be the beginning of a negative divergence between the twomarkets.BONDS AND STOCKS SHOULD BE ANALYZED TOGETHER
The moral of this chapter is that since bonds and stocks are historically linked together, technical analysis of one without a corresponding analysis of the other isincomplete. At the very least a stock market trader or investor should be monitoring the bond market for confirmation. A bullish technical forecast for bonds is alsoa bullish technical forecast for stocks. Conversely, a bearish analysis for bonds is abearish forecast for stocks. As demonstrated in Figures 4.1 and 4.2, the technical signals in bonds (such as stochastics buy and sell signals) usually lead similar signalsin stocks. At the worst the signals are usually coincident. Analysts can use movingaverages or any other tools at their disposal. The important thing is that bond activitybe factored into the stock market analysis.WHAT ABOUT LONG LEAD TIMES?
Although the charts of recent market history show a remarkable day-to-day correlationbetween bonds and stocks, turns in the bond market often lead those of stocks bylong periods of time. The September 1981 bottom in bonds, for example, precededthe stock market bottom in August 1982 by 11 months. The April 1987 breakdownin bonds preceded the August stock market top by four months. How, then, does thestock market analyst take these long lead times into consideration?The bond market is an important background factor in stock market analysis.Buy and sell signals for stocks are given by the stock market itself. If the bond marketstarts to diverge from the stock market, a warning is being given—-the more serious thedivergence, the more important the warning. In the summer of 1987, as an example,the collapse in the bond market simply warned the stock market trader that somethingwas wrong. The stock market trader, while not necessarily abandoning long positionsin stocks during the summer of 1987, might have paid greater attention to initial signsof impending weakness on his stock charts.In 1981 and 1982 the bottoming action in the bond market gave the stock market traders plenty of warning that the tide might be turning. Even if the stock traderignored the bottoming activity in bonds up to the summer of 1982, the bullish breakout in bonds in August of 1982 might have caused a stock market trader to becomemore aggressive in buying into the stock market rally. The long lead times in bothinstances, while less helpful to the short-term trader, were probably most useful toportfolio managers or those investors with a longer time horizon.Having acknowledged the existence of occasional long lead times between thetwo markets, it should also be pointed out that on a day-to-day basis there is oftena remarkable correlation between the two markets. This correlation can even be seenon an hour-to-hour basis on many days. Even for short-term timing, it's a good ideato monitor the activity in the bond market.
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SHORT-TERM INTEREST RATE MARKETS AND THE BOND MARKET
Our main concern has been with the bond market. However, for reasons that weretouched on in Chapter 3, it's also important to monitor the trend action in the Treasury bill and Eurodollar markets because of their impact on the bond market. Actionin these short-term money markets often provides important clues to bond marketdirection.During periods of monetary tightness, short-term interest rates will rise fasterthan long-term rates. If the situation persists long enough, short-term rates may eventually exceed long-term rates. This condition, known as an inverted yield curve, isconsidered bearish for stocks. (The normal situation is a positive yield curve, wherelong-term bond yields exceed short-term market rates.) An inverted yield curve occurs when the Federal Reserve raises short-term rates in an attempt to control inflationand keep the economy from overheating. This type of situation usually takes placenear the end of an economic expansion and helps pave the way for a downturn in thefinancial markets, which generally precedes an economic slowdown or a recession.The action of short-term rate futures relative to bond futures tells whether ornot the Federal Reserve Board is pursuing a policy of monetary tightness. In general,when T-bill futures are rising faster than bond futures, a period of monetary ease isin place, which is considered supportive to stocks. When T-bill futures are droppingfaster than bond prices, a period of tightness is being pursued, which is potentiallybearish for stocks. Another weapon used by the Federal Reserve Board to tightenmonetary policy is to raise the discount rate.
HISTORICAL PERSPECTIVE
53
FIGURE 4.10AN EXAMPLE OF THE "THREE STEPS AND A STUMBLE" RULE. SINCE 1987, THE FEDERAL RESERVE BOARD HAS RAISED THE DISCOUNT RATE THREE TIMES IN SUCCESSION. HISTORICALLY, SUCH ACTION BY THE FED HAS PROVEN TO BE BEARISH FOR STOCKS.Stocks versus the Discount Rate
THE "THREE-STEPS-AND-A-STUMBLE" RULE
Another manifestation of the relationship between interest rates and stocks is theso-called "three-steps-and-a-stumble rule." This rule states that when the FederalReserve Board raises the discount rate three times in succession, a bear market instocks usually follows. In the 12 times that the Fed pursued this policy in the past 70years, a bear market in stocks followed each time. In the two-year period from 1987to 1989, the Fed raised the discount rate three times in succession, activating the"three-steps-and-a-stumble rule" and, in doing so, placed the seven-year bull marketin equities in jeopardy (see Figure 4.10).Changing the discount rate is usually the last weapon the Fed uses and usuallylags behind market forces. Such Fed action often occurs after the markets have begunto move in a similar direction. In other words the raising of the discount rate generallyoccurs after a rise in short-term money rates, which is signalled by a decline in theT-bill futures market. Lowering of the discount rate is usually preceded by a risein T-bill futures. So, for a variety of reasons, short-term futures should be watchedclosely.It's not always necessary that the bond and stock markets trend in the samedirection. What's most important is that they don't trend in opposite directions. Inother words if a bond market decline begins to level off, that stability might be enoughto push stock prices higher. A severe bond market selloff might not actually pushstock prices lower but might stall the stock market advance. It's important to realizethat the two markets may not always move in lockstep. However, it's rare when theimpact of the bond market on the stock market is nonexistent. In the end it's up to thejudgment of the technical analyst to determine whether an important trend changeis taking place in the bond market and what impact that trend change might have onthe stock market.
HISTORICAL PERSPECTIVE
Most of the focus of this study has been on the market events of the past 15 years. Itwould be natural to ask at this point if these intermarket comparisons hold up over alonger span of time. This brings us to a critical question. How far back in history canor should the markets be researched for intermarket comparisons? Prior to 1970 wehad fixed exchange rates. Movements in the U.S. dollar and foreign currencies simplydidn't exist. Gold was set at a fixed price and couldn't be owned by Americans.The price of oil was regulated. All of these markets are critical ingredients in theintermarket picture.There were no futures markets in currencies, gold, oil, or Treasury bonds. Stockindex futures and program trading hadn't been invented. The instant communicationbetween markets that is so common today was still in the future. Globalization wasan idea whose time hadn't yet come, and most market analysts were unaware ofthe overseas markets. Computers didn't exist to permit study of interrelationships.Technical analysis, which is the basis for intermarket work, was still practiced behindclosed doors. In other words, a lot has changed in the last two decades.
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What needs to be determined is whether or not these developments have changedthe way the markets interact with each other. If so, then comparisons prior to 1970may not be helpful.THE ROLE OF THE BUSINESS CYCLE
Understanding the economic rationale that binds commodities, bonds, and the stockmarket requires some discussion of the business cycle and what happens during periods of expansion and recession. For example, the bond market is considered anexcellent leading indicator of the U.S. economy. A rising bond market presages economic strength. A weak bond market usually provides a leading indication of aneconomic downturn (although the lead times can be quite long). The stock marketbenefits from economic expansion and weakens during times of economic recession.Both bonds and stocks are considered leading indicators of the economy. Theyusually turn down prior to a recession and bottom out after the economy is wellinto a recession. However, turns in the bond market usually occur first. Going backthrough the last 80 years, every major downturn in the stock market has either comeafter or at the same time as a major downturn in the bond market. During the lastsix recessions bonds have bottomed out an average of almost four months prior tobottoms in the stock market. During the postwar era stocks have begun to turn downan average of six months prior to the onset of a recession and have begun to turn upabout six months prior to the end of a recession.Tops in the bond market, which usually give earlier warnings of an impendingrecession, are generally associated with rising commodity markets. Conversely, during a recession falling commodity markets are usually associated with a bottom inthe bond market. Therefore, movements in the commodity markets also play an important role in the analysis of bonds and stocks. The economic background of theseintermarket relationships will be discussed in more depth in Chapter 13.WHAT ABOUT THE DOLLAR?
Discussions so far have turned on the how the commodity markets affect the bondmarket and how the bond market affects stocks. The activity in the U.S. dollar playsan important role in the intermarket picture as well. Most market participants wouldagree with the general statement that a rising dollar is bullish for bonds and stocksand that a falling dollar is bearish for bonds and stocks. However, it's not as simpleas that. The U.S. dollar hit a major top in 1985 and dropped all the way to January1988. For a large part of that time, bonds and stocks rose as the dollar weakened.Clearly, there must be something missing in this analysis.The impact of the dollar on the bond and the stock markets is not a direct onebut an indirect one. The impact of the dollar on bonds and stocks must be understoodfrom the standpoint of the dollar's impact on inflation, which brings us back to thecommodity markets. To fully understand how a falling dollar can be bullish for bondsand stocks, one must look to the commodity markets for answers. This will be thesubject of Chapter 5.SUMMARY
This chapter discussed the strong link between Treasury bonds and equities. A rising bond market is considered bullish for stocks; a falling bond market is considered
SUMMARY
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bearish. However, there are some qualifiers. Although a falling bond market is almostalways bearish for equities, a rising bond market does not ensure a strong equitymarket. Deteriorating corporate earnings during an economic slowdown may overshadow the positive effect of a rising bond market (and falling interest rates). While arising bond market doesn't guarantee a bull market in stocks, a bull market in stocksis unlikely without a rising bond market.
5
COMMODITY PRICE TRENDS-THE KEY TO INFLATION
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FIGURE 5.1THE US. DOLLAR VERSUS TREASURY BOND PRICES FROM 1985 THROUGH 1989. ALTHOUGHA RISING DOLLAR IS EVENTUALLY BULLISH FOR BONDS AND A FALLING DOLLAR ISEVENTUALLY BEARISH FOR BONDS, LONG LEAD TIMES DIMINISH THE VALUE OF DIRECTCOMPARISON BETWEEN THE TWO MARKETS. DURING ALL OF 1985 AND MOST OF 1986,BONDS WERE STRONG WHILE THE DOLLAR WAS WEAK.U.S. Dollar Index versus Bonds1985 through 1989
Commodities and the U.S. D