TRADING WITH INTERMARKET ANALYSIS
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TRADING
WITH
INTERMARKET
ANALYSIS
A Visual Approach
to Beating the Financial Markets
Using Exchange-Traded Funds
Copyright © 2013 by John J. Murphy. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Murphy, John J.
Trading with intermarket analysis: a visual approach to beating the financial markets using exchange-traded funds / John J. Murphy.
p. cm.—(Wiley trading series)
Includes index.
ISBN 978-1-118-31437-1 (cloth); ISBN 978-1-118-41996-0 (ebk);
ISBN 978-1-118-43399-7 (ebk); ISBN 978-1-118-42158-1 (ebk)
1. Investment analysis. 2. Exchange traded funds. 3. Stocks. I. Title.
HG4529.M8625 2012332.63’27—dc23
2012020566
To chartists everywhere.
CONTENTS
Acknowledgments
Introduction
PART I The Old Normal
Chapter 1 Intermarket Analysis: The Study of Relationships
All Markets Are Related
Asset Allocation Strategies
ETFs Have Revolutionized Intermarket Trading
Sector Rotation and the Business Cycle
Stocks Peak and Trough before the Economy
The Role of Oil
Advantages of Using Charts
Viewing the Big Picture Is Important
Intermarket Implications for Technical Analysis
A New Dimension to Technical Work
Intermarket Work Is an Evolutionary Step
Why Relationships Change
Intermarket Principles
Review of the Old Normal
CHAPTER 2: Review of the Old Normal
1980 Was a Key Turning Point
The End of the Inflationary 1970s
The 1987 Crash Reinforced Intermarket Trends
The Two Iraq Wars
The 1994 Stealth Bear Market Follows Intermarket Script
Echoes from the 1930s
The Japanese Bubble Bursts in 1990
Chapter 3 The 1997–1998 Asian Currency Crisis
The Asian Currency Crisis Starts in 1997
Bonds and Stocks Start to Decouple
1997 and 1998 Were Only a Dress Rehearsal
Intermarket Lessons of 1997 and 1998
The Asian Effect Overrides the Fed
Two Deflationary Events of the 1990s
Deflationary Effect on Bond Yields
Japanese Deflation and U.S. Interest Rates
Summary
PART II The 2000 and 2007 Tops
Chapter 4: Intermarket Events Surrounding the 2000 Top
Events Leading up to the 2000 Top
Crude Oil Triples in Price
A Rise in Short-Term Rates Leads to an Inverted Yield Curve
REITs Benefit from Falling Stocks
Consumer Staples Start to Outperform
Market Lessons from 2000
Bonds, Stocks, and Commodities Peaked in the Proper Order
The 2002 and 2003 Bottoms Reverse Normal Order
The Fed Discovers Deflation during 2003
Commodities Turn Up during 2002
Chapter 5: The 2002 Falling Dollar Boosts Commodities
Commodities Inflate
Commodities Gain from Battle against Deflation
The Dollar Drop Leads to a New Bull Market in Gold
Falling Stocks Are Also Good for Gold
Not a Lot of Alternatives
Gold and the Dollar Experience Major Trend Changes
Shifting from Paper to Hard Assets
The Stock Peak Coincides with Gold Bottom
Gold Breaks 15-Year Resistance Line
Stocks End Secular Uptrend
Gold Outperforms Stocks for the First Time in 20 Years
The Oil Peak Coincides with the 2003 Stock Bottom
Chapter 6: Asset Allocation Rotations Leading to 2007 Top
Relative Strength between Asset Classes
Asset Allocation
2002 Shift from Paper to Hard Assets
The Commodity/Bond Ratio Also Turned Up
Turns in the Bond/Stock Ratio
The 2007 Bond/Stock Ratio Shifts Back to Bonds
Bonds Rise as Stocks Fall During 2007
Falling U.S. Rates Hurt the Dollar
The Falling Dollar Pushes Gold to a Record High
The Three Markets Peaked in the Right Order
No Such Thing as Global Decoupling
Chapter 7: Visual Analysis of the 2007 Market Top
Combining Traditional Charting with Intermarket Warnings
The NYSE Advance-Decline Line Shows Negative Divergence
What Caused the Divergence?
Rising Oil Hurts Transportation Stocks
The Dow Theory
Consumers Are Also Squeezed by Rising Oil
Retailers and Homebuilders Were Linked
Retail Stocks Start to Underperform Long before 2007
The 2005 Homebuilding Top Gave Early Warning
Another Bearish Warning During 2007
Why Breadth Measures Work
Summary
PART III The Business Cycle and ETFs
Chapter 8: Intermarket Analysis and the Business Cycle
The Four-Year Business Cycle
The Presidential Cycle
The Business Cycle Explains Intermarket Rotation
Lessons from 2000 and 2007
Oil Leads to Higher Rates from 2004 to 2006
The 2001 Fed Easings Didn’t Work
Comparisons to the 1920s and 1930s
Rotating Asset Classes over Decades
Lessons of Long Cycles
The Kondratieff Wave
Dividing a Lifetime Cycle into Seasons
Housing Is Interest Rate Sensitive
Real Estate Doesn’t Always Follow Rates
Real Estate Doesn’t Always Follow Inflation
The 18-Year Real Estate Cycle
The Real Estate Peak Was Overdue
Economic Cycles Set the Framework for Intermarket Work
Chapter 9: The Impact of the Business Cycle on Market Sectors
Sector Rotation within the Business Cycle
Sector Rotations during 2000 Favored Contraction
Sector Rotations during 2003 Favored Expansion
Technology Leadership Is Another Good Sign
Smaller Stocks Lead at Bottoms
Transportation Leadership
2007 Sector Rotation Showed Weakness
Sector Rotation Has Two Sides
It’s Also a Market of Groups
The Difference between Sectors and Industry Groups
Sector Rotation Model
Sector Rotations during 2007
Industry Group Leadership
Sector Rotations Turn Positive in 2009
Sector Trends Need to Be Monitored
2011 Rotations Follow Sector Rotation Model
Performance Bars
Using Sector Carpets to Find Leading Stocks
Comparing Absolute and Relative Performance
Sectors Are an Important Part of Intermarket Work
The Emergence of Exchange-Traded Funds
Chapter 10: Exchange-Traded Funds
Mutual Funds versus ETFs
Top ETF Providers
Stock Market ETFs
Bond ETFs
Commodity ETFs
Currency ETFs
Trading the Dollar
Foreign ETFs
Inverse and Leveraged ETFs
Summary
PART IV The New Normal
Chapter 11: The Dollar and Commodities Trend in Opposite Directions
Both Markets Need to Be Analyzed Together
The Rising Dollar Contributed to the 1997–1998 Commodity Collapse
The Falling Dollar from 2002 to 2008 Pushed Commodities Higher
The Dollar Bottom during 2008 Contributed to Commodity Plunge
Dollar Peaks in 2009 and 2010 Lifted Commodities
The Dollar Bottom in 2011 Pushed Commodities Lower
Correlation Coefficient
Gold Isn’t Like Other Commodities
Commodities Are Linked to Foreign Currencies
Gold Outperforms the Euro
Gold Outpaces Other Commodities
Gold versus Foreign Currencies
The Dollar’s Impact on Other Intermarket Trends
Chapter 12: Stocks and Commodities Become Highly Correlated
Another Side Effect of the Deflationary Environment
Commodities Lost Half Their Value in Just Six Months
Stock and Commodities Became Closely Correlated after 2008
Copper Influences Stock Market Direction
The Silver/Gold Ratio Influences the Stock Market
Silver Stocks Led Commodity Lower during 2011
The Influence of Commodities on Sector Performance
Commodities Led Stocks Lower during 2011
The Commodity Peak Also Influenced Sector Rotations
Gold Stocks versus Gold
Gold Miners Are Stocks
Gold Shares Underperform Bullion during 2011
Gold and Miners Relink during July
Dollar Direction Impacts Foreign Stocks
Chapter 13: Stocks and the Dollar
A Weak Historic Link between the Two
A Long-Term Comparison of Stocks and the Dollar
Stocks and the Dollar Become Negatively Correlated
The Commodity Impact on the Dollar-Stock Link
The Dollar Bottom during 2011 Hurts Stocks
The Dollar Impact on Foreign Stocks
Commodities Are Linked to Emerging Markets
China Influences Copper Trend
Chinese Stocks Influence the S&P 500
Europe Is Also Important
Currency Trends Impact Foreign ETFs More
France iShares Hold 2010 Support
EMU iShares Diverge from Euro
EAFE and Emerging iShares Stabilize at End of 2011
Don’t Forget about Canada
The Canadian Dollar versus the Euro
Canadian Markets and Commodities
How to Add the Americas to Your Foreign Portfolio
Chapter 14: The Link between Bonds and Stocks
The Two Markets Compete for Investor Funds
The Positive Correlation between Bond Yield and Stocks
Bond Yield Leads Stocks Lower during 2010 and 2011
The Falling Bond Yield Boosts Dividend-Paying Stocks
Consumer Staples and Utilities Thrive on Rising Volatility
Not All Bonds Are the Same
Some Bond Prices Can Trend in Opposite Directions
Quantitative Easing
The Impact of Quantitative Easing on Bonds and Stocks
Operation Twist
The Yield Curve
Thr Impact of Quantitative Easing on the Yield Curve
Bond Yield and Stocks Diverge at the Start of 2012
TIPS and Gold Rise Together
The Pendulum Swings Back to Stocks at the Start of 2012
The Fed Launches QE3
Chapter 15: The Link between Bonds and Commodities
One of the Traditional Relationships
Bond and Commodity Prices Normally Trend in Opposite Directions
The Inverse Bond-Commodity Link between 2003 and 2006
Why They Changed during 2007
Copper versus Corn during 2002
A Comparison of Copper and Treasury Bond Prices
The Copper Bottom during 2009 Contributed to the Bond Top
The Thomson Reuters/Jefferies CRB Index
The CRB Index/Treasury Bond Ratio
The Commodity/Bond Ratio Since 2008
The CRB/Bond Ratio Influences Stocks
The History of Commodity/Bond Ratio Influence on Stocks
The CRB/Bond Ratio Also Influences Sector Rotation
The CRB/Bond Ratio also Influences Emerging Markets
Commodity Inflation versus Bond Deflation
Commodity and Bond Links to China and Japan
Summary
Conclusion
Recap of Intermarket Principles
The New Normal in Intermarket Relationships
Fed Policy May Be Interfering with Normal Bond/Stock Relationship
The Fed Also Kept Bond Yields Low during the 1940s
Asset Allocation Strategies May Start Favoring Stocks
The Nasdaq/Bond Ratio May Be Bottoming
The Nasdaq Composite Index Hits a 12-Year High
Banks Show New Leadership
Homebuilders Bottom
Adding a New Dimension to Technical Analysis
Reading Up on Charting
StockCharts.com Chart School
Neural Networks
Looking Ahead
A Dollar Bottom Would Have a Depressing Effect on Commodities
A 40-Year Trend of the CRB Index
The Stock/Commodity Ratio Favors Stocks over Commodities
Trade trends, not opinions
About the Author
Index
ACKNOWLEDGMENTS
I would like to begin by thanking Pamela Van Giessen, long-time Executive Editor at Wiley, for guiding me through several earlier books and for encouraging me to do one more. Her successor in that role, Evan Burton, convinced me that a new generation of e-books, with beautiful color graphics and digital enhancements, lent itself extremely well to visual market analysis, and would help bring intermarket analysis to a wider audience. I’m glad he did. I would also like to thank Judy Howarth at Wiley for working so closely with me in the complicated task of putting the book together, and for making my part in doing that much easier. All of the charts in this book were done on the Stockcharts.com web site. I would like to thank the president of that organization, Chip Anderson, for creating new market indicators for my use in this book, and for providing historical market data that was extremely useful. I’ve learned from many other writers over the years. Special mention is owed to Sam Stovall, chief investment strategist for Standard & Poor’s, for his work on sector rotation throughout the business cycle. Thanks also to John Creegan Jr. for his expertise in foreign exchange trading. Also to Ted Bonanno, my agent, who helped smooth the way. Finally, I’d like to thank readers of my earlier books on intermarket analysis who encouraged me to write something more current on that exciting field. This book is for them. And, of course, for newer readers interested in intermarket analysis.
INTRODUCTION
My first book on this subject, entitled Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets (Wiley & Sons), was published in 1991. The reason I wrote the book was to demonstrate that all global financial markets are closely linked and have an impact on each other. The book’s main thesis was that technical analysts needed to broaden their chart horizon to take these intermarket relationships into consideration. Analysis of the stock market by itself, for example, was incomplete without taking into consideration existing trends in the dollar, bond, and commodity markets. That first book suggested that financial markets could often be used as leading indicators of trends in related markets or, at the very least, could provide confirmation (or nonconfirmation) of other existing trends.
Because the message of that earlier text challenged the single market focus of the technical community, some professional chartists questioned whether this newer and broader intermarket approach had any place in the technical field. Many questioned whether intermarket relationships existed at all or, if they did, whether they were consistent enough to provide any forecasting value. A paper on the subject that I once submitted to the Market Technicians Association (MTA) was rejected due to lack of proof. The seemingly revolutionary idea that all global markets are linked, and that American analysts could gain some edge by following trends in foreign markets, was also viewed with skepticism. How things have changed in the two decades since then.
Twenty years later, intermarket analysis is considered a branch of technical analysis and an increasingly popular one. A poll taken by the Journal of Technical Analysis asked the membership of the Market Technicians Association to rate the relative importance of various technical disciplines. Of the 14 technical disciplines included in the poll, intermarket analysis ranked fifth. In addition, my second book on the subject, entitled Intermarket Analysis: Profiting from Global Market Relationships (Wiley Trading, 2004), is now required reading for the MTA’s Chartered Market Technician (CMT) program—the very program that rejected my earlier paper on the same subject. (The Chartered Market Technician program is a three-step certification process administered by the Market Technicians Association (mta.org) in which candidates are required to demonstrate proficiency in technical analysis. Successful candidates are awarded the professional designation of Chartered Market Technician.) It is certainly gratifying to see intermarket analysis come such a long way in the last two decades and to finally become such an accepted part of technical market analysis. After reading this book, I hope you’ll agree with me that intermarket analysis has also become an increasingly indispensable part of it.
My first intermarket book (1991) reviewed the hyperinflationary decade of the l970s ending with the bursting of the commodity bubble in 1980, which, in turn, led to major upturns in bonds and stocks in the early 1980s and ushered in two decades of disinflation and bull markets in bonds and stocks. It also analyzed the 1987 stock market crash, which, for me, turned intermarket theory into reality. It ended with a description of global events leading up to the start of the first Persian Gulf War as 1990 drew to a close. My second book on that subject (2004) took up where the first book left off and drew comparisons between the first Iraq war during 1990–1991 and the second war 13 years later, in 2002–2003. The actual start of both wars helped launch new bull markets in stocks during 1991 and 2003. The second book also described market trends in the 1990s, which included the stealth bear market during 1994, which offered another lesson in intermarket relationships. A huge spike in the price of oil was a big contributing factor to that year’s losses in bonds and stocks.
Two watershed events took place during the 1990s that helped introduce a new word into the financial commentary: deflation. The collapse of the Japanese stock market in 1990 and the Asian currency crisis during 1997–1998 raised deflation concerns for the first time since the 1930s. My 2004 book described how the threat of deflation as the 1990s ended changed some important intermarket relationships, and contributed to the bursting of the Nasdaq bubble as the new century started. Many of those changes are still in effect more than a decade after that first market top of the new millennium. The 2004 book ended with the start of a new bull market in stocks during the spring of 2003 (caused partially by a collapse in oil prices at the start of the second Iraq war).
My next book, entitled The Visual Investor, Second Edition (Wiley Trading, 2009), covered market events surrounding the 2007–2008 financial meltdown, which was caused in no small part by the worst housing collapse since the Great Depression. That book showed how to combine traditional charting techniques with intermarket principles to get a complete picture of what was happening. As this book is being written nearly five years later, many of the effects of that global meltdown are still being felt.
This book will review events since 2000 with a view toward demonstrating that the threat of deflation throughout the past decade has dominated most intermarket relationships, as well as Federal Reserve policy. The start of the commodity boom during 2002 was the direct result of the Fed’s devaluation of the U.S. dollar in an attempt to stem deflationary pressures (a technique that was also tried during the 1930s). One of the most important intermarket changes that will be described has to do with the changing relationship between bonds and stocks, which decoupled in the years after 1998. In the decades before 1998, rising bond prices supported rising stock prices. Starting in 1998, however, rising bond prices hurt stock values, which was a new phenomenon that became painfully evident from 2000 to 2002 during the worst stock plunge since the Great Depression, and again during the 2008 financial collapse.
A second intermarket change has been the increasingly close linkage between stock and commodity prices since the bursting of the housing bubble during 2007, which was also reminiscent of the deflationary 1930s. Since 2008, stocks and commodities have trended pretty much in lockstep. That’s because both are tied to global economic trends. The events surrounding the 2008 market meltdown reinforced another economic lesson having to do with the link between markets and the economy. The stock market is a leading economic indicator. Stocks usually peak and trough ahead of the economy. The Great Recession following the housing collapse started in December 2007 (three months after stocks peaked) and ended in June 2009 (three months after stocks bottomed). It was also the longest and deepest economic downturn since the Great Depression of the 1930s. No wonder the Fed started to use the same playbook that was used back in that earlier era.
In my view, three major deflationary events have occurred over the last 20 years. The first was the peak in Japanese stocks starting in 1990, which turned into a deflationary spiral in the world’s second biggest economy (at that time). The second was the Asian currency crisis during 1997–1998. The third event was the housing collapse during 2007. Those three deflationary events led to a new normal in intermarket relationships that exists as we enter the second decade of the new century. Explaining what those new normal relationships are, and how you can take advantage of them, is the purpose of this book.
Intermarket analysis is very visual. Although the relationships described herein are based on sound economic principles, and are backed up by correlation statistics, my approach relies heavily on being able to see those relationships on price charts. As a result, you’re going to see a lot of charts. The use of color graphics in this edition will make those comparisons a lot easier to see and a lot more striking. Rest assured that you won’t have to be a chart expert to understand the charts. All you’ll need is the ability to tell up from down. And an open mind.
This chapter covers the main points of intermarket analysis, starting with the observation that all markets are related. It will also introduce asset allocation and sector rotation strategies at various stages of the business cycle, and explain how stocks peak and trough before the economy. Other points include the important role played by crude oil, how exchange traded funds have revolutionized intermarket trading, the advantage of using charts, why viewing the big picture is important, intermarket implications for technical analysis, how its adds a new dimension to technical work, why it’s an evolutionary step, and why relationships change. It will end with a recap of intermarket principles.
As the name implies, intermarket analysis is the study of how various financial markets are related to each other. This is a departure from prior forms of market analysis, which relied primarily on a single-market approach. Stock market analysts, for example, used to spend their time analyzing the stock market, which included market sectors as well as individual stocks. Stock traders didn’t have much interest in what was happening in bonds, commodity markets, or the dollar (not to mention overseas markets). Fixed-income analysts and traders spent their time analyzing the bond market without worrying too much about other markets. Commodity traders had their hands full tracking the direction of those markets and didn’t care much about other asset classes. Trading in currency markets was limited to futures specialists and interbank traders.
That is no longer the case. Traditional chart analysis has taken a major evolutionary step over the last decade by adopting a more universal intermarket approach. I like to think that my two earlier books on intermarket analysis (published in 1991 and 2004) helped move things in that direction. It would be unthinkable today for a trader in any one of those four asset classes not to study trends in the other three.
JOHN’S TIPS
The four asset classes involved in intermarket work are bonds, stocks, commodities, and currencies.
Some understanding of how the different asset classes interact with each other is important for at least two reasons. First, such an understanding helps you appreciate how other financial markets influence whichever market you’re primarily interested in. For example, it’s crucial to know how bonds and stocks interact. If you’re trading stocks, you should be watching bonds because bond prices usually trend in the opposite direction of stocks. In many cases, turns in the bond market actually precede turns in stocks. Bond yields are inversely correlated with bond prices. That being the case, falling bond yields (rising bond prices) can be a negative warning for stocks.
Figure 1.1 compares the yield on the 10‐year Treasury note to the S&P 500 during 2000. After peaking that January (first arrow), the bond yield started falling a lot faster than the stock market. By that spring, the bond yield had fallen to the lowest level in a year while the S&P 500 was still trending sideways (although the Nasdaq peaked that spring). The S&P 500 didn’t start falling until the fourth quarter of that year (second arrow) and entered a major bear market that lasted for more than two years. That’s a pretty dramatic example of falling bond yields giving early warning that the stock market was in trouble. It demonstrates how the bond market usually changes direction before stocks at major turning points and is often a leading indicator of the stock market. Figure 1.1 also demonstrates why it’s so important for stock analysts to take trends in the bond market into consideration.
If you’re a bond trader, you should be watching trends in commodity markets. A jump in commodity prices, for example, is usually associated with a drop in bond values. In another illustration of how one market impacts on another, a falling U.S. dollar usually results in rising commodity prices. And, as you’ll see later in the book, the direction of the U.S. currency helps determine the relative attractiveness of foreign stocks compared to those in the United States.
A second reason why it’s important to understand intermarket relationships is to help with the asset allocation process. There was a time not too long ago when investors’ choices were limited to bonds, stocks, or cash. Asset allocation models were based on that limited philosophy. Over the last decade, however, investment choices have broadened considerably. Since 2002, for example, commodities have been the strongest asset class and are now recognized by Wall Street and the investing public as a viable alternative to bonds and stocks. The emergence of exchange‐traded funds (ETFs) has had a lot to do with the increasingly popularity of commodity trading. The same is true for foreign currency markets, which have also had a strong run since 2002.
Consider the relative performance of those four asset classes since the start of 2002 when the U.S. dollar started a major decline that eventually took it to a record low. During the 10‐year span starting in 2002, commodity prices gained 64 percent. By comparison, bond prices gained 23 percent, while U.S. stocks experienced a relatively modest gain of 9 percent. The main catalyst in the commodity upturn was a 32 percent drop in the U.S. dollar. That’s because the dollar and commodities trend in opposite directions. A falling dollar results in higher commodity prices.
JOHN’S TIPS
Commodity prices and foreign currencies trend in the same direction and in the opposite direction of the U.S. dollar.
Figure 1.2 compares the trend of the U.S. Dollar Index to the CRB Index of commodity prices between 2000 and 2008. It’s clear that the two markets trended in opposite directions. It can also be seen that the major upturn in commodity prices began during 2002 (up arrow) at the exact same time that the dollar started dropping (down arrow). The inverse relationship between the dollar and commodity markets is one of the most consistent and reliable relationships in intermarket work.
Foreign currencies also benefit from a falling dollar. That’s especially true for currencies tied to countries that export commodities like Australia and Canada. During the 10 years starting in 2002, the Aussie dollar (boosted by rising commodity prices) gained 101 percent versus 50 percent for the euro. It’s clear that investors have benefited from the ability to expand their asset allocation choices beyond bonds and stocks. Exchange‐traded funds are a big reason why.
Exchange‐traded funds have had a lot to do with expanding those choices into alternate assets like commodities and currencies. In fact, the explosive popularity of ETFs has revolutionized the world of intermarket trading and has made it increasingly easy to implement global intermarket strategies. During the 1990s, for example, the ability to incorporate commodities and currencies into one’s portfolio was almost impossible outside of the futures markets. The growing availability of ETFs has made investing in commodity and currency markets as easy as buying a stock on a stock exchange. Exchange‐traded funds can be used for virtually any asset class anywhere in the world. Mainly for that reason, we’ll be relying very heavily on ETFs throughout this book to show how markets interact and how to take advantage of those interactions. Another place where ETFs have become extremely popular is in implementing sector rotation strategies.
Intermarket analysis plays an important role in sector rotation strategies. The U.S. stock market is divided into market sectors (which are further subdivided into industry groups).
JOHN’S TIPS
The stock market has 10 sectors and approximately 90 industry groups.
Exchange‐traded funds are available that cover all market sectors (and most industry groups). That greatly facilitates the movement into and out of various market sectors at different stages of the business cycle. I’ll show you later in the book how to use intermarket principles (and some simple charting techniques) to spot leading and lagging market sectors for the purpose of ensuring that you’re in the leaders and out of the laggards. You’ll also learn how tracking sector rotation offers valuable insights into the direction of the stock market and the economy.
Near the start of a new bull market in stocks, economically sensitive groups like consumer discretionary stocks (which include retailers) usually do better than most other stocks. So do technology and transportation stocks, which are tied to the business cycle. Small-cap stocks also lead at market bottoms. Near market tops, those very same groups usually turn down first. Energy stocks (which are tied to the price of oil) have a tendency to become market leaders near the end of a bull market in stocks. Energy leadership is almost always a dangerous warning sign for the stock market. One of the ways to tell that the stock market is peaking is when money starts to flow out of energy stocks and into defensive sectors like consumer staples, health care, and utilities. I’ll show you how to spot those rotations and how to take advantage of them. And what they mean.
Important tops in the stock market usually lead to periods of economic weakness (or recessions). The 2000 stock market top, for example, led to a recession the following spring. The October 2007 market top led to a recession that December. The same is true at market bottoms. The ending of the last two recessions during 2003 and 2009 followed market upturns a few months earlier. When the stock market weakens, money tends to rotate out of stocks and into bonds. At market bottoms, the opposite happens. Money rotates out of bonds and back into stocks. Fortunately, it’s pretty easy to spot those shifts in investor sentiment, which we’ll demonstrate later in the book. It’s hard to separate trends in financial markets from trends in the economy. Intermarket analysis sheds light not only on market direction but the economy as well. You’ll also see later in the book that bonds, stocks, and commodities have a history of peaking and troughing in a predictable order during turns in the business cycle.
JOHN’S TIPS
Bonds usually change direction first at tops and bottoms, stocks turn second, and commodities third.
That knowledge will help you determine where to be at different stages of the business cycle. It will also help you determine whether the business cycle is turning up or turning down.
Rising oil prices from the beginning of 2007 preceded a stock market downturn later that year. Oil’s role in the 2007 market top wasn’t an aberration. In fact, it was very normal. Rising oil prices have contributed to every U.S. recession in the last 40 years. Rising oil prices have also contributed to stock market peaks and resulting bear markets. That was certainly the case during the mid‐1970s when a tripling in the price of crude during 1973 (during the Arab Oil Embargo) led to a 50 percent stock market loss the following year (1974). Spikes in the price of crude also preceded or accompanied stock market drops during 1987, 1990, 1994, and 2000. By contrast, sharp drops in the price of crude have usually had a bullish impact on stocks. That was the case at the start of the two Iraq wars in early 1991 and 2003, which helped launch new bull markets in stocks. That’s why market leadership by stocks tied to oil is normally a danger to the stock market. That’s also why our intermarket analysis has to always consider what the price of oil is doing. Upward spikes in oil prices have preceded most stock market peaks.
JOHN’S TIPS
Rising oil prices usually force the Fed to raise interest rates, which weakens the stock market and slows the economy.
Figure 1.3 compares the price of crude oil to the S&P 500 during 2007 and 2008. The chart shows two consistent intermarket tendencies. The first is that rising oil prices usually precede stock market peaks. Crude started climbing at the start of 2007 (first up arrow). After a modest pullback during August, crude turned up even more sharply that September (second up arrow). The stock market peaked a month later during October (first down arrow). Rising oil is usually a warning sign for stocks and has led to most market tops. The second intermarket lesson is that oil usually peaks after stocks do. Figure 1.3 shows crude peaking during July 2008 (second down arrow), nine months after the stock top.
All of this talk about intermarket relationships may start sounding like a lot of economic theory. This is partially the case because intermarket analysis is based on economic principles. However, it is not theory. Intermarket work is market‐driven. There is nothing theoretical about a profit-and-loss statement. Economists look at economic statistics to determine the direction of the economy and, by inference, the likely direction of financial markets. By contrast, chartists look at the markets themselves. That makes a big difference. Economic statistics by their very nature are backward‐looking. What else could they be? They tell us what happened last month or last quarter. They tell us nothing about the future (or the present, for that matter). The markets, however, are forward‐looking entities. That’s why the markets are called discounting mechanisms. Stocks anticipate (or discount) economic trends six to nine months into the future. There’s also a reason some markets are called futures. Which would you rather depend on: backward‐looking statistics or forward‐looking markets? Put another way, would you rather place your trust in a lagging or a leading indicator of future market trends? Economists rely on lagging economic indicators, while chartists place their trust in forward‐looking financial markets.
JOHN’S TIPS
While stocks usually change direction before the economy, bonds usually change direction before stocks. That makes bonds an even earlier economic indicator than stocks.
This distinction goes to the heart of technical analysis, which is based on the premise that markets are leading indicators of their own fundamentals. In that sense, chart analysis is a shortcut form of economic and fundamental analysis. This is one reason why intermarket analysts use charts. Charts also offer a big advantage in intermarket work because they allow us to look at so many different markets. It’s hard to imagine how anyone could study and compare markets all over the world in all asset classes without the use of charts. Besides making comparisons of so many markets much easier, it’s not even necessary to be an expert in any of those markets. All one needs is knowledge of how to plot the charts and the ability to determine which markets are going up and which ones are dropping. Intermarket work goes a step further by determining if two related markets are moving in the same or in opposite directions.
The biggest benefits of the visual tools described in this book are their universality and transferability. They can be applied to any market anywhere in the world—and to any time dimension. They can be applied to short‐term trading as well as long‐term investing. Any market that can be charted can be analyzed. That gives the chartist an enormous advantage over those who prefer to use some form of economic or fundamental analysis. Those two schools of analysis have a number of problems to deal with. The economist is forced to deal with old data. The fundamental analyst (who studies company and industry earnings) has a tremendous amount of data to deal with. That prevents the fundamental analyst from covering a wide variety of markets. As a result, fundamental analysts are forced to specialize. The intermarket chartist, by comparison, can follow any market he or she wishes to anywhere in the world without having to be an expert in any one of them. That’s a pretty big advantage in an interrelated world of intermarket analysis and trading. More importantly, the ability to scan so many markets from different asset classes all over the world provides the intermarket chartist with a big‐picture view of what’s really happening. That’s a huge advantage over the tunnel vision that’s so often seen among market analysts who follow only a small portion of the financial spectrum.
Because intermarket work involves looking at so many markets, it has to be done with price charts. Chart analysis is the easiest and most efficient way to study intermarket linkages. Intermarket work greatly expands the usefulness of technical analysis. It allows analysts like me to talk about things that used to be restricted to security analysts and economists, like inflation, deflation, the direction of interest rates, the impact of the dollar, and the state of the business cycle. Some understanding of how bonds, stocks, and commodities rotate during the business cycle, for example, allows us to talk about the state of the economy. Sector rotation also sheds light on whether the economy is contracting or expanding.
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Consumer discretionary stocks lead early in an economic expansion. Energy leadership occurs near the end of an expansion. Consumer staples are strongest during an economic downturn.
The financial markets are leading indicators of economic trends. It took the Federal Reserve until the spring of 2003 to acknowledge the threat of deflation. The markets had spotted the threat years earlier. It also took the Fed a lot longer than it took chart analysts to recognize the threat from the housing collapse during 2007. The events surrounding stock market peaks during 2000 and 2007 demonstrated the need to incorporate some chart and intermarket analysis into economic and fundamental forecasting. It took the Wall Street community too long to figure out what many chartists already knew during the first half of 2000 and 2007 when warning signs of a market top were clearly visible, and that the economy was headed for trouble (as you’ll see in the following chapters). The idea that technical analysis is a shortcut form of fundamental analysis is based on the premise that price action in any market is a leading indicator of that market’s fundamentals. A lot of Wall Street analysts (and their clients) paid a big price for ignoring the clear chart signals that the markets were giving off during 2000 and 2007. They also paid a price for ignoring intermarket signals.
The greatest contribution made by intermarket analysis is that it improves the market analyst’s peripheral trading vision. Trying to trade markets without intermarket awareness is like driving a car without looking at the side and rearview mirrors and windows. Intermarket analysis includes all markets everywhere on the globe. By turning the focus of the market analyst outward instead of inward, intermarket work provides a more rational understanding of forces at work in the marketplace. It provides a more unified view of global market behavior. Intermarket analysis uses activity in surrounding markets in much the same way that analysts use internal market indicators. Intermarket analysis doesn’t replace traditional technical analysis; it adds another dimension to it.
I like to think that intermarket analysis represents another step in the evolution of technical theory and practice. With the growing recognition that all global markets are linked, traders can take these linkages into consideration more and more in their analysis. Because of its flexibility and its universal application to all markets, technical analysis is uniquely suited to perform intermarket work.
Intermarket analysis provides a more useful framework for understanding how individual markets and sectors relate to one another. Throughout most of the 20th century, technical analysis had an inward focus. This new century has witnessed a much broader application of technical principles not just to financial markets themselves, but also to their wider implications for economic forecasting. Even the Federal Reserve looks to the financial markets to get clues about the future course of the economy. It has to use charts to do that. The intermarket principles presented in this book offer a much broader view of the future of technical analysis. I believe that intermarket analysis will play an increasingly important role in that future.
To ignore market interrelationships is to ignore enormously valuable price information. What is worse is that it leaves market analysts in the position of not understanding the external forces that move the market in which they are trading. The days of following only one market are gone. Market analysts need to know what is happening in all of the financial markets and must understand the impact of trends in those related markets all over the world. Technical analysis has enormous transferability in moving from one market to another, and is extremely useful in comparing the relative performance of those markets.
JOHN’S TIPS
Technical analysis can be applied to any market and asset class, and can also be used for short‐term trading and long‐term investing.
Intermarket relationships are not static. While most remain constant over long periods of time, they sometimes change for short periods. Some changes are more long lasting. As you’ll see shortly, that is what happened between bonds and stocks. Nothing changes, however, without a reason. The changing relationship between bonds and stocks that started as the old century came to a close signaled that business cycles after 2000 would be different from other downturns since World War II. That became especially true after the housing collapse during 2007, which precipitated the worst financial meltdown since the Great Depression. Government attempts to turn the business cycle back up relied on traditional fiscal and monetary measures, which had worked in the past. Unfortunately, they didn’t work as well this time.
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It’s much harder to fight deflation than inflation. After lowering short‐term rates to zero over the last decade, the Fed couldn’t lower them any further and had to resort to other measures.
That was because the business cycle after 2000, and especially after 2007, wasn’t like other traditional postwar business cycles. Deflationary pressures overrode those traditional government measures. Some of the intermarket changes that took place near the start of this century, and again after 2007, gave us plenty of warning that this time would be different.