Inter-Market Relationships Analysis
A Daily Review of Global Capital Market Trends For Sophisticated Investors
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Let's get at it...
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Thursday, January 11, 2001
Chart Presentation: Market Relationships 101
We were especially pleased to find that the removal of our negative opinion on the Internet sector just happened to come one day in front of Yahoo!’s earnings warning and the subsequent $5 to $6 drubbing in its stock price in after hours trading. Nicely timed.
It is rather obvious that advertising revenues from dot.coms will be down this year but we rather suspect that Yahoo! will still be standing when the dust finally settles in this sector. Valuation levels are still troublesome, of course, but we find that the cyclical stocks are never appealing based on fundamentals at ‘the bottom’.
Here is a question: why are we so concerned with discerning ‘the top’ for the bond market? The answer is that it is vital for figuring out what to do in the equity markets. To explain we have included comparative charts of the S&P 500 Index and the U.S. T-Bond futures. The top chart shows the 1989-90 period while the lower chart focuses on 1986-87.
We have communicated two rather conflicting messages over the past few days. We have argued that bond market weakness will be a net negative for the equity markets while at the same time shifting toward a more positive stance on the growth/tech sectors. Inconsistent? Hopefully not. Let’s give it a shot...
Why do bond prices peak (interest rates bottom) after a lengthy run? Because whatever slack there might have been in the economy has been used up. The problem here is that it is difficult to understand how the economy could be strong when everyone knows that it is weakening quickly. It is also hard to grasp the idea that interest rates have bottomed when the Fed has just begun to reduce interest rates. However, to really grasp this point we are going to ignore the news of the day and focus on the message of the markets. If bond prices peak for the cycle and turn downward THEN money is moving towards RISK and away from safety. Period.
When the bond market peaks there are three things that you have to pay attention to. First, the equity markets will remain strong for the next 5 to 7 months. Second, in the shorter term the equity markets will get pulled downward by falling bond prices. Third, as soon as the bond market finds some area of support and stops falling, equity prices accelerate upward. In 1987, for instance, bond prices turned down in the spring, causing the equity markets to chop through April and May. As bonds prices settled down, equity prices moved higher. This is the basic relationship that we are working off of and the key reason we are so concerned with the bond market at this time.
Equity Markets
There are two major points that we want to make today. First, weak bond prices have a negative impact on the equity markets. Second, that doesn’t mean that the equity markets have to decline. Why? Because it depends on WHY bond prices are falling. If money fled into the bond market to avoid risk and is now returning, then the growth-oriented sectors will get a boost while the more interest rate-sensitive sectors will decline. In general, however, the S&P 500 Index tends to work sideways or down with a falling bond market and then upward afterwards. The Nasdaq, however, should be stronger.
At right is a short term chart of the S&P 500 Index. Notice, once again, that it has been trading lower in a well defined channel and is still below its 50-day moving average. Prices have moved nicely from the bottom of the channel back up to the top on several occasions over the past two months.
After hitting the channel bottom this index has ‘flagged’ upward. Tests of the channel bottom have come every 2 1/2 to 3 weeks so we are now in the time frame where another shot lower could be expected. We will have to respect the downward trend until about 1330-35 is broken on a closing basis. If, on the other hand, the bottom of the ‘flag’ is taken out by a close under about 1295 then the first logical support area would be around 1260. Any spike down toward 1220 would meet with good support as well.
Bond/Equity Markets
The S&P 500 Index chart shows that while the equity markets are in a steeply declining trend they actually spend more time working upward than they do moving lower since the declines tend to be quite quick. If falling bond prices can push stock prices lower, is there any way to know when the bond market will peak? Actually, we believe that it already has.
At bottom right is a chart of the T-Bond futures using candlesticks. The upward channel has already been broken to the downside. A move below 104 would certainly be negative.
Using the price spread between the 30-year T-Bond futures and the 10-year T-Note futures (which moves ‘with’ the bond market) we can see quite clearly that ‘the peak’ was likely seen during the first few days of January, coinciding with the last price peak in the S&P Retail Index and the move over 700 by the S&P 100 Index (OEX).
This is an interesting chart comparison because we get some sense of how different sectors move at different times. The general bond market environment has been positive (spread line rising) since mid-October. The Retail sector has moved nicely higher while the OEX traded roughly ‘flat’ on either side of 700. During the last positive period- from the end of May through into early September- the OEX moved consistently higher while the Retail sector chopped back and forth in a flat trend.
So what? This simply suggests that the overall market will hold rather well if the bond market continues lower. Why? Those areas that benefitted from rising bond prices will decline while those areas that were weak will rebound. We still believe that ‘the market’ and ‘the news’ are telling different stories and that the cyclical areas offer the best potential once bond prices find support.
Currency/Bond/Equity Markets
If we circle all the way back to our original point- that the equity markets tend to suffer somewhat while bond prices fall and then move sharply higher for toward the final ‘peak’- we need to mention once again that bonds and utilities tend to top at the same time. The weakest part of our bonds/equities argument would be that the current bond rally is NOT a major top but either a bear market bounce after the 1998 bond market highs or the first stage in a multi-year bond bull market. Yet...there is the utility sector to consider. The DJUI is coming off of record highs and the top in 1998 can barely be seen now.
Our argument is, and has been, that the utility sector works off of both the dollar and the bond market. We use the Tbond futures in German Dmark terms as a surrogate for the trend in the utility sector. Both peaked at the end of last year and have turned nicely lower.
But...the dollar has been quite strong lately while bond prices work lower. Can the dollar move higher here? No.
At right, once again, is the comparative chart of the U.S. 2-year Notes futures and the ratio between the Tbond futures and the U.S. Dollar Index.
While the Fed eased monetary policy this past month, we argue that the market has been easing since the moment the Fed raised rates last May. The 2-year Note has regained just about all the ground that it lost from the December peak. (By the way, we use December 1998 as ‘the peak’ for the bond market that year since this was when energy prices turned upward). The long end of the bond market has pushed higher but has been held back by the strong dollar. In other words, the short end of the yield curve is still leading by a substantial margin.
If the Tbond futures have peaked but the Tbond/Dollar ratio is 10-15% too low, how can we get from ‘here’ to ‘there’? Not with a strong dollar. If the Tbonds back down to, say, 102, then a low to mid-90 level on the U.S. Dollar Index is very possible.
If there is one relationship that has the potential to turn ‘bad’ into ‘worse’ this may well be it. We show the Japanese yen futures against the Dow Jones Industrial Index.
After shooting all of its fiscal and monetary ammunition, Japan’s economy remains in a slump. Recognizing this, the currency markets are taking one last shot at reinflating Japan by driving its currency lower vis-a-vis the dollar and the euro. The longer this weak currency trend continues, the bigger the problem.
The chart comparison shows a very close relationship between the basic trend of the yen and that of the DJII. This is so compelling that we will add a standing comment on the summary page today to the effect that IF the DJII closes below 9900 we will move to a hard negative opinion on this index. With the DJII + Nasdaq = S&P 500 this could easily take place if money began to shift back to the Nasdaq and out of the DJII- leaving the S&P 500 relatively flat.
Kevin Klombies
IMRA
Recommendations and Inter-Market Summaries From Previous Issues- January 11, 2001
Equity Markets
Turning more positive on the equity markets but require a break up through the 50-day moving average by either the S&P’s or the Nasdaq. However, additional yen weakness coupled with a DJII close below 9900 would bring us back to sharply negative on the DJII and possibly back to negative on the equity markets as a whole.
Bond Markets
Looking for bond market peak in Dec./Jan. period. A drop in heating oil/unleaded gasoline ratio through 1.1:1 should do it. (That ratio has broken lower so we are negative on bond prices).
Currency Markets
We view anything above 113.30-.50 on the U.S. Dollar Index as extreme and would definitely be buyers of the euro below .80. Sept. 28: Exited the Cdn dollar. Oct. 11: positive on euro on a close above .8705. Nov 30: Stopped in on euro. Positive on the Australian and Cdn dollars.
Commodity Markets
Negative view on commodity prices in general through until the fourth quarter of 2001. The Japanese yen tends to peak about 10 months before the CRB Index.
Crude oil prices are fairly valued in the $28-$34 range, with $38 representing a channel extreme.
Gold will need a turn in the euro/Swiss franc in order to move back above $300. Oct. 10: Positive on gold- positive on XAU on a close through 45.50- adjusted down to 43.30 on Nov. 17. Nov. 21: XAU stopped us in.
We are positive on the grains, cotton, and coffee (as of Dec 4).
