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markets interact with each other that gives them their predictive value. Hereis how they interrelate:• The U.S. dollar trends in the opposite direction of commodities• A falling dollar is bullish for commodities; a rising dollar is bearish• Commodities trend in the opposite direction of bond prices• Therefore, commodities trend in the same direction as interest rates• Rising commodities coincide with rising interest rates and falling bondprices• Falling commodities coincide with falling interest rates and rising bondprices• Bond prices normally trend in the same direction as stock prices• Rising bond prices are normally good for stocks; falling bond prices are bad• Therefore, falling interest rates are normally good for stocks; rising ratesare bad• The bond market, however, normally changes direction ahead of stocks• A rising dollar is good for U.S. stocks and bonds; a falling dollar can be bad• A falling dollar is bad for bonds and stocks when commodities are rising• During a deflation (which is relatively rare), bond prices rise whilestocks fallThe list sums up the key intermarket relationships between the four market groups—at least as they are in a normal inflationary or disinflationaryenvironment, the likes of which existed during the second half of the last century. This held up especially well during the 1970s, the 1980s, and most of the1990s. (The last item in the preceding list which refers to deflation was notnormal in the postwar era. Later in the book I explain how deflationary pressures starting in 1997 and 1998 changed the normal relationship that hadexisted between bonds and stocks.) With a basic understanding of intermarket relationships, it is easier to see how well the markets followed that scriptat the start of the 1980s. A rising dollar led to falling commodities, which ledto rising bond prices, which led to rising stock prices. Things stayed prettymuch this way until 1987.
1987 STOCK MARKET CRASH REVISITEDThe stock market crash during the second half of 1987 was an even moredramatic example of the necessity for intermarket awareness. It happenedswiftly and the results were dramatic and painful. Those who ignored the
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action in related markets during the first half of that year were blindsided bythe market collapse during the second half. As a result, they sought outscapegoats like program trading and portfolio insurance (futures-relatedstrategies that can exaggerate stock market declines) to explain the carnage.While these two factors no doubt added to the steepness of the stock market decline, they did not cause it. The real explanation for the stock marketcrash that year is much easier to explain, but only if viewed from an intermarket perspective. It started in the bond and commodity pits in the springof that year.
COMMODITIES RISE, BONDS FALLDURING SPRING OF 1987During the four years after 1982, two of the main supporting factors behindthe stock market advance were falling commodity prices (low inflation) andrising bond prices (falling interest rates). In 1986, both of those marketsstarted to level off; commodities stopped going down and bond pricesstopped going up. The intermarket picture did not really turn dangerous,however, until the spring of 1987. In April of that year, the CRB Index ofcommodity prices turned sharply higher and “broke out” to the highest levelin a year. At the same time, bond prices went into a virtual freefall. (Risingcommodity prices usually produce lower bond prices.) These intermarkettrend changes removed two of the bullish props under the stock marketadvance and gave an early warning that the market rally was on weak footing. Figure 1.4 shows the inverse relationship between bond and commodityprices from 1985 to 1987. It shows the CRB Index rising above a neckline (atrendline drawn over previous peaks) in the spring of 1987 (which completed a bullish head and shoulders bottom) just as bond prices were fallingunder the lower trendline in a yearlong triangular pattern—a bad combination for stocks since it suggested that rising inflation was pushing interestrates higher.
STOCK MARKET PEAKS IN AUGUSTThe stock market rally continued for another four months into August 1987before finally peaking. The fact that bond prices peaked four months ahead ofstocks demonstrates the tendency for bonds to turn ahead of stocks. Again,
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FIGURE 1.4
The inverse relationship between bond prices and commodities canbe seen from 1985 through 1987. The bond market collapse in thespring of 1987 coincided with a bullish breakout in commodities.
bonds are considered to be leading indicators of stocks. Figure 1.5 shows thedivergence between bond and stock prices from the spring of 1987 (whenbonds peaked) until August (when stocks peaked). Bonds fulfilled their roleas a leading indicator of stocks. By October, bond yields had climbed above 10percent. Probably more than any other factor, this jump in interest rates todouble-digit levels caused the October stock market crash. Figure 1.6 showsthat the October 1987 plunge in stocks followed closely after bond yieldsclimbed over 10 percent. In addition, the U.S. dollar played a role.
DOLLAR FALLS WITH STOCKSThe dollar, which had been declining earlier in the year, started a rebound inMay that lasted into the summer. This rebound ended in August as the stock
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FIGURE 1.5
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Bonds versus stocks during 1986 and 1987. Bonds collapsed in Aprilof 1987 and preceded the August peak in stocks by four months.
market peaked. Both markets then fell together. A second rally attempt bythe dollar during October also failed, and its subsequent plunge coincidedalmost exactly with the stock market crash. Figure 1.7 shows the closecorrelation between the peaks in the dollar and stocks during August andOctober 1987. Consider the sequence of events going into the fall of 1987.Commodity prices had turned sharply higher, fueling fears of renewed inflation. At the same time, interest rates soared to double digits. The U.S. dollarsuddenly went into freefall (fueling even more inflation fears). Is it any wonder that the stock market finally ran into trouble? Given all of the bearishactivity in the surrounding markets, it is surprising that the stock marketheld up as well as it did for as long as it did. There were plenty of reasons whythe stock market should have sold off in late 1987. Most of those reasonswere visible in the action of surrounding financial markets—like commodi-
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FIGURE 1.6
The surge in bond yields in the summer and fall of 1987 had abearish influence on stocks. From July to October of that year,Treasury bond yields surged from 8.50 percent to over 10.00percent. The surge in bond yields was tied to the collapsingbond market and rising commodities.
ties and bonds—but not necessarily in the stock market itself. The events of1987 provide a textbook example of how intermarket linkages work. Thattraumatic market year also makes a compelling argument as to why stockmarket participants need to monitor the other three financial markets.
THE 1987 MARKET CRASH WAS GLOBALAnother important lesson of 1987 is the fact that the market crash was globalin scope—world markets fell together. This is important for two reasons.First, it is a dramatic demonstration of how global stock markets are linked.
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FIGURE 1.7
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The falling U.S. dollar during the second half of 1987 also weighedon stock prices. The twin peaks in the U.S. currency in August andOctober of that year coincided with similar peaks in the stockmarket. The collapse in the U.S. dollar in October also paralleledthe drop in equities.
Second, it shows that world stock markets become even more closely linkedduring serious downturns than they are normally. At such times, global diversification becomes a myth. (The same phenomenon of a global bear market instocks is apparent starting in 2000.) Global linkages are not limited to stockmarkets, either. Foreign currencies are linked to the U.S. dollar. Trends ininflation and deflation (which are reflected in commodity prices) are global.There is another lesson having to do with the global nature of the 1987stock market crash. Many market observers at the time took the narrowview that various futures-related strategies—like program trading and portfolio insurance—actually caused the selling panic. They reasoned that theredid not seem to be any economic or technical justification for the stock
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market collapse. The fact that the equity crash was global in nature, and notlimited to the U.S. market, argued against such a narrow view, especiallysince most foreign markets at the time were not affected by program tradingor portfolio insurance.
LATER EXAMPLES OF GLOBAL LINKAGESDuring the Iraq crisis of 1990 and again in 2003, rising energy prices slowedglobal economic growth and contributed to weakness in all of the world’smajor stock markets. The rise in oil prices during 1990 also pushed interestrates higher all over the world and once again showed how global interest ratesrise and fall together. After 1998, a close correlation developed between falling global interest rates—including those in the United States—and a fallingJapanese stock market, which was caught in the grip of deflation. Figure 1.8shows interest rates moving higher around the globe during the inflationary1970s and then falling together during the disinflationary 1980s and the deflationary 1990s.
THE DOLLAR’S IMPACT CAN BE DELAYEDOf the four financial markets used in intermarket work, the dollar is probably the most difficult to fit into a consistent intermarket model. Long delaysbetween trend changes in the dollar and other markets are part of the reasonfor that. The events leading up to 1987 provide a good example of why this isso. After rallying for five years, the dollar started to drop in 1985, largely dueto the Plaza Accord, a five-nation agreement designed to drive down the priceof the dollar. Normally, a falling dollar would give a boost to commodityprices. But this boost did not come—at least not right away. It was not untila year later—in 1986—that the commodity decline that started in 1980 startedto level off and bond prices stopped going up. When commodities started torally during the spring of 1987, the real problems started. It took almost twoyears for the falling dollar to stimulate a serious rally in commodities—andcause problems for bonds and stocks. Figure 1.9 shows the lag time betweentwo events (the 1985 dollar peak and the 1986 bottom in commodity prices)and the upturn that took place during the spring of 1987. The falling dollareventually had an impact, but it took a year or two for it to take effect.Intermarket trends during the 1980s also show why the impact of thedollar’s direction on bonds and stocks needs to be filtered through the com-
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FIGURE 1.8
Global bond yields rose during the inflationary 1970s and fell during thedisinflationary 1980s and 90s. Global rates usually rise and fall together.
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FIGURE 1.9
The U.S. dollar versus the CRB index from 1985 through the fourthquarter of 1989. A falling dollar will eventually push the CRB indexhigher. The 1986 bottom in the CRB index occurred a year after the1985 peak in the dollar.
modity markets. A falling dollar can be bearish for bonds and stocks, but onlyif it coincides with rising commodity prices. (It can also be said that a fallingdollar is not a serious problem until it starts to push interest rates higher,which is usually the result of rising commodity prices.) A falling dollar cancoexist with rising bond and stock prices, as long as commodity prices do notrise. The decline of the dollar that started in 1985 did not have much of animpact on either bonds or stocks—until commodity prices (and interestrates) turned up during April 1987. Figure 1.10 shows the delayed effect of afalling dollar on interest rates. The dollar peaked in 1985. Bonds peaked oneyear later, but did not really start tumbling until the spring of 1987. A falling
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FIGURE 1.10
The U.S. dollar versus Treasury bond prices from 1985 through1989. A falling dollar is eventually bearish for bonds. During allof 1985 and most of 1986, bonds were strong while the dollarwas weak.
dollar became a problem for stocks when its inflationary impact pushed bondprices lower and interest rates higher.Some have argued that the generally weak dollar in the years between1985 and 1995 did not have much of a negative impact on bonds and stocks.There is some validity to this argument, since bonds and stocks continued toenjoy major advances during those 10 years. However, it is also true thatdollar peaks in 1985 and 1989 preceded the 1987 and 1990 bear markets (inbonds and stocks) by two years and one year, respectively. In addition, commodities rallied during both bear markets as a result of that dollar weakness.It is also true that the 1994 bear trend in bonds and stocks followed anotherpeak in the dollar and an upturn in commodity prices.
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ONWARD AND UPWARD TO 1990Bond and stock prices stabilized during the fourth quarter of 1987 and begana two-year advance that lasted from the start of 1988 to the end of 1989. Theintermarket picture during those two years had reverted to a more benignalignment: a strong dollar, weak commodities, and rising bond and stockprices. At the start of 1990, however, things took a turn for the worse. Itstarted with a drop in bond prices, a selloff in the dollar, and a rally in commodities, all of which are negative signs for the stock market. Then came theIraqi invasion of Kuwait in early August of that year. Oil prices spiked to $40per barrel. The result was a bear market in stocks and a recession. Becauseof the lessons that can be learned from studying the intermarket relationships of 1990 and their relevance to geopolitical events 13 years later, we willexamine that landmark year in more depth in the next chapter.
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CHAPTER 2
1990 and the FirstPersian Gulf War
n the fall of 1990, my earlier book on intermarket analysis was just goingto press.1 In the Appendix, I included charts of the most important intermarket relationships through the third quarter of that year. It was gratifying to see how well the markets followed their intermarket script despite theMideast crisis that gripped the global financial markets during the summer of1990. But that was only part of the story. Iraq invaded Kuwait in August of thatyear, which made a bad situation even worse. However, intermarket relationships had started to deteriorate at least six months earlier. As was the case during 1987, the deterioration started in the bond and commodity pits during thefirst half of the year. Bonds started to fall at the start of the year, while commodity prices rose. The dollar was weak. Then things went from bad to worse.After the Kuwait invasion, crude oil soared to $40 a barrel which pushedstock markets lower all over the world. Gold prices also jumped as the dollar and stocks weakened. These are both classic intermarket relationships.Interest rates jumped all over the world in reaction to higher energy prices.The result was the start of a recession in the United States a month after theinvasion. (This was not the only time that rising oil prices had contributed toa U.S. recession. The U.S. economy had suffered four recessions since1970. Three of the four—those that took place in 1974, 1980, and 1990—wereaccompanied by surging oil prices. Nine years later, surging oil prices in 1999contributed to the onset of another recession and, in the process, helpedburst the bubble in the Nasdaq market.) Interestingly, the stock market suffered its biggest losses during the five months following the 1990 Iraq invasion.
I
1
Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond,Commodity, and Currency Markets, John Wiley & Sons, 1990.
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Once the war actually started (on January 16, 1991), all of the preexistingintermarket relationships reversed. Gold and oil tumbled while stocks soared.Both at the start and at the end of this earlier Mideast crisis, the traditionalintermarket relationships held. Some intermarket trends had already startedto change, however, at the start of 1990 in the futures pits. Let’s start there.
BONDS TURN DOWN IN EARLY 1990At the beginning of 1990, treasury bond prices had been rising for almost twoyears. Starting in January, however, bond prices started to drop sharply andcontinued to do so until October of that year (more on that later). To useintermarket parlance, a negative divergence was created between bonds andstocks. As was the case in 1987, it was an early warning of stock marketproblems to come. Part of the reason that bond prices were falling was a risein commodity prices—also just like the situation in 1987. Figure 2.1 is a snap-
FIGURE 2.1
Charts of the four sectors—the dollar, CRB Index, stocks,and bonds—through the third quarter of 1990. A weakdollar during most of 1990 helped support commodityprices and put downward pressure on bonds and stocks.
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shot of the four markets—the dollar, the CRB Index, stocks, and bonds—through the first three quarters of 1990. A falling dollar boosted commoditiesand hurt bonds during the first half of the year, which hurt stocks during thesecond half of the year.
CRB TURNS UP IN EARLY 1990The CRB Index of commodity markets was rising at the start of 1990. Thatwas partly due to a drop in the dollar during the second half of 1989, whichcoincided with a rebound in commodity markets. As 1990 wore on, the dollar dropped even more sharply. During most of 1990, a weak dollar helpedsupport commodity prices and put downward pressure on bonds and stocks.Figure 2.2 shows how the falling dollar from the fourth quarter of 1989 to thefourth quarter of 1990 gave a big boost to commodity prices. The CRB rally
FIGURE 2.2
A comparison of the CRB Index to the U.S. dollar fromlate 1989 to September 1990. The falling dollar,which is inflationary, helped commodity pricesadvance during 1990. A bounce in the dollar duringMay contributed to the CRB peak that month.Commodities firmed again during the summer asthe dollar dropped to new lows.
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FIGURE 2.3
A comparison of the CRB Index and Treasury bonds fromlate 1989 through the third quarter of 1990. During thefirst half of 1990, commodities rallied while bondsweakened. The bond bottoms in early May and lateAugust (see arrows) were accompanied by peaks incommodity prices.
from late 1989 through the first half of 1990 was caused by rising agriculturalmarkets, many of which peaked by that summer. This explains the top in theCRB Index during May of that year. Gold and oil both turned up that summerand carried the CRB rally into October when it peaked for good. Those CRBpeaks during May and October coincided with bond bottoms. Figure 2.3shows that commodity prices rose during the first half of 1990, coincidingwith a downturn in the bond market. It also shows two peaks in the CRBIndex producing bond rallies.
BONDS AND STOCKS DIVERGEBy May of 1990, bond prices had fallen more than 10 percent, while stockprices remained relatively flat. From May to August, bonds and stocks re-
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FIGURE 2.4
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Stocks versus bonds from late 1989 through September1990. After falling through the early portion of 1990, thebond trough in early May helped support the stock rally.Bonds failed to confirm the Dow’s move to new highsduring the summer. Both markets then tumbled together.
bounded together. During these three months, the Dow Industrials gained300 points (10 percent) and reached a record high. Bonds regained only 50percent of their first half’s losses, and never came close to reaching theirearlier highs. This set up a bearish divergence between bonds and stocks.By August, both tumbled together. Figure 2.4 shows the negative divergencethat existed between bonds and stocks heading into the summer of 1990,months before the dramatic geopolitical events that started during August.
GLOBAL MARKETS DON’T CONFIRM U.S. RALLYMajor world markets like Britain, Japan, and the United States weakened atthe beginning of 1990 and then rallied in the spring. Only the U.S. market,however, rallied to a new high. Neither of the other foreign markets confirmedthe U.S. move into record territory during the summer of 1990. When any one
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FIGURE 2.5
A comparison of American, British, and Japanese stockmarkets in the 18-month period ending in the third quarterof 1990. All three markets dropped sharply at the beginningof 1990 and then rallied in the spring. Neither of the foreignmarkets confirmed the American rally to new highs duringthe summer of 1990. The “triple top” in Britain and thecollapse in Japan held bearish implications for Americanequities. Global markets then collapsed together.
global market (even one as big as the United States) is the only one to reacha new high, it qualifies as a global divergence. Figure 2.5 shows that the U.S.stock market was the only one to hit a new high during the summer of 1990.A bearish triple top pattern was forming in Britain. The Japanese market,which had peaked at the end of 1989, never recovered. It fell for another 13years. The triple top in Britain and the collapse in Japan held bearish implications for U.S. equities.
IRAQ INVADES KUWAIT IN AUGUSTOn August 2, 1990, Iraq invaded Kuwait, which set events in motion that ledup to the 1991 Persian Gulf War. As it turns out, it was not much of a war.
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But it threw a scare into the financial markets for the six months leading upto the actual outbreak of hostilities. How the markets reacted to the geopolitical situation was in itself another lesson in intermarket linkages.Each and every market did pretty much what was expected of it duringthe period leading up to the war. Bonds and stocks fell, as did the dollar.Gold and oil prices rose sharply. This was also a global phenomenon thataffected bond and stock prices all over the world. From August to October,major declines were seen in the bond markets of Britain, Germany, Japan,and the United States—while oil prices soared. With oil rising all over theworld, and global bonds falling, major stock markets everywhere tumbledas well. Figure 2.6 shows how rising crude oil prices in 1990 pushed bondprices downward in the United States, Britain, Germany, and Japan. It wastruly a global event.
FIGURE 2.6
A comparison of the American, British, German, and Japanesebond markets during the summer of 1990. Global bond marketstumbled as oil prices surged following Iraq’s invasion of Kuwaiton August 2, 1990. Japanese bonds turned in the worstperformance (owing to Japan’s greater dependence on oil), notonly leading global bond prices lower but also accounting forthe collapse of Japanese equities.
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OIL AND GOLD SOARThe inflationary impact of rising oil prices during the summer of 1990 took abearish toll on equity prices around the globe. Oil became the dominant commodity during that year and demonstrated in dramatic fashion how sensitivebond and stock markets are to action in the commodity sector. Gold pricesalso jumped, although not as dramatically as oil. Starting in August, goldprices rose over $60 (almost 20 percent) before finally peaking. (Like oil,gold has a history of trending in the opposite direction of the stock market.)Any comparison of gold or oil during the second half of 1990 (and early 1991)will show the two key commodities moving in the opposite direction ofthe stock market, which is their normal pattern. Figures 2.7 and 2.8 show the
FIGURE 2.7
Dow Industrials versus crude oil during the summer of 1990.The inflationary impact of surging oil prices during the summerof 1990 took a bearish toll on equity prices everywhere on theglobe. Oil became the dominant commodity during 1990 anddemonstrated how sensitive bond and stock markets are toaction in the commodity sector.
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FIGURE 2.8
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Gold versus the Dow Industrials from the summer of1989 to the autumn of 1990. The gold rally in the fallof 1989 coincided with stock market weakness. TheFebruary 1990 peak in gold coincided with a rally instocks. Gold rose during the summer of 1990 as stocksweakened. Throughout the period shown, gold did bestwhen the stock market faltered.
inverse correlation between the two key commodities—gold and oil—andthe stock market in 1990. The weak dollar fell even harder after the invasion,which added more strength to the rallies in oil and gold. Gold and oil stockscontinued to rally while the rest of the market tumbled. Figure 2.9 showshow the falling dollar in 1990 gave a boost to gold prices, especially at thestart of the year and at mid-year.
EVERYTHING REVERSES AT THE START OF WARAs so often happens in the financial markets, the anticipation of an event isusually worse than the event itself. The markets discount expected eventswell before they happen. The event can be anything from a bad earningsreport to a war. And, as so often happens, the markets reverse on the actual
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FIGURE 2.9
The U.S. dollar versus gold from late 1989 throughSeptember 1990. The declining dollar during most of 1990wasn’t enough to turn the gold trend higher. However, theinverse relationship can still be seen, especially duringthe dollar selloffs in late 1989 and June 1990, when goldrallied. The interim bottom in the dollar in February 1990was enough to push gold prices lower.
event when it does occur. At least this is what happened in mid-January 1991when the Persian Gulf War started. The bombing of Iraq started on theevening of January 16, 1991. The following trading day, gold and oil pricestumbled while stocks soared. Within a month, the dollar had put in a bottomand turned higher.Figure 2.10 shows gold and oil prices tumbling at the outbreak of war inmid-January 1991. Both commodities had turned up that August just after theIraq invasion of Kuwait. Oil had actually peaked at $40 during October butwas attempting another rebound during January 1991. The outbreak of warcaused oil to lose almost half of its value within a month. Gold declined from$400 to $350 in the three months after the war started. A big bounce in thedollar contributed to the commodity selloff. At the same time, a major rotation took place after the war started. Only this