Inter-Market Relationships Analysis
SummaryIt is always difficult to suggest that what you do is unique, but I think it would be somewhat fair to say that the views that I present in the IMRA are at least a bit unusual. This represents my efforts, over many years, to come up with an explanation for what the various capital markets are doing. Perhaps it would be best to start somewhere near the beginning and work forward.
I became interested in the equity markets during the late 1970’s while a university student in Canada. Since I didn’t have any capital to speak of, I formed two different investment clubs and used those funds for my first real trading. My Honors thesis dealt with geographical portfolio diversification and I was hired by a Canadian investment dealer upon graduation. My love affair with investment had truly begun.
After getting beaten and battered from time to time by major trend changes, I finally decided to stop relying on the reams of fundamental and technical research that were at my disposal- and that was reliably wrong at major turning points- and get serious about figuring things out for myself. In order to have any confidence, I needed to know what made the markets really tick. After hundreds and hundreds of hours of studying charts, printing them out, drawing lines, cutting and pasting different charts together, I finally began to see some of the cycles and underlying trends that would form the basis for my work. To a large extent I stopped reading the opinions of others in order to keep my own views as pure as possible and in time developed many of my inter-market theories. To my surprise years later, I found that there was an established, although somewhat basic, body of work on intermarket relationships, but to this day I have never given it more than a cursory glance.
I deal with the equity, fixed income, foreign exchange, and commodity markets. I try and determine what the movement or changes in trend in one market may mean to the others. There is no ‘one’ overriding theme to what I do, nor is there any specific purpose other than to forecast trend changes and explain current action. Perhaps that is enough.
While there are many things that I pay strict attention to, there are others that I largely ignore. I pay little heed to volume, for instance, which would make most technical analysts shudder. I only recognize a small handful of technical chart patterns and work only exclusively with channels. I have found that when I can discern the proper channel- by which I mean two parallel lines that determine the top and bottom of a trend- I have almost everything I need. Obviously the shorter your time frame, the less useful this form of analysis might be.
Currency trends tend to run on for years and are extremely powerful in that they help to explain the direction of the flow of liquidity. There are some currencies that I would call naturally strong, since those countries run persistent current account surpluses, and others that are naturally weak for the same but opposite reason. If a currency like the U.S. dollar moves into an uptrend, then it is only because an inordinately large amount of capital is moving toward the U.S. Why? Is it because their short-term interest rates are being held artificially high or is it because of some fundamental reason to do with growth? Is capital being pulled or is it being pushed? Is it because growth prospects are rising in one area or diminishing in another? What would that mean to commodity prices? What are the usual lags between major changes in interest rates and gold, oil, or the agricultural complex? What currencies tend to move with or ahead of changes in certain commodities? What effects do major trend changes in the bond market have on the equity market and with what lag?
To me, fundamental research is limited in its usefulness because it is based on a set of economic assumptions that are usually wrong. I find that it is far easier to forecast the economy off of the financial markets than to make market predictions off of an economic forecast. Since most analysts deal with a specific group of companies or a specific industry, they must build their assumptions upon a foundation given to them by their economists. While an economic cycle or trend continues, chances are the conclusions will be valid, but at major turning points we end up with ‘garbage in, garbage out’.
I also find that most technical analysis is interesting but limited as well. If one were to draw a trend line and suggest that support or resistance has just been broken, I would ask ‘why’? Beyond that, is there confirmation from other markets? If not, why not? Is this a major turning point or simply a minor bump on a long-term chart that will soon disappear? I am always looking for confirmations and divergences.
What do I believe in? I believe in Kondratieff’s 50-55 year cycle. I believe that market cycles repeat, but never in the same way. I believe that if you don’t know what you are looking for, chances are you won’t find it. I believe that you must have a thesis to trade successfully and that you must have a way of constantly checking to see if your thesis is correct. I believe that there are consistent leads and lags between markets. I believe in seasonality, quarterly trends, month end distortions, and the consistency of human psychology. I believe that as trends mature they often get faster. I believe that when a trend goes parabolic, it should be viewed through logarithmic charts. I believe in trend lines and channels. I believe, above all else, that the markets are always rational. If you think otherwise, you simply do not understand what is going on.
To get to the heart of the matter, I have selected six inter-market relationships that tend to be relatively consistent over time and may help with your understanding of what the markets are doing and why. There are many other relationships that I work with that may be consistent through a cycle but will vary from one to the next. As an explanation, I consider a market cycle to begin with the bottom in the bond and equity markets and continue until both have bottomed once more. These generally last 2-4 years, with 3 years being a reasonable average i.e. there were equity bear markets in 1981, 1984, 1987, 1990, 1994, and in many parts of the world, 1997.
Let’s begin.
- Bonds and Commodities
Of all the relationships, this has to be one of my favorites, since it operates on two distinct levels. In real time, rising commodity prices tend to push bond prices lower, while falling commodity prices lead to higher bond prices. In other words, there is a distinct inverse relationship- most of the time. On the other hand, there is also a lagged relationship that is rarely noticed, but is equally powerful. Commodity price trends follow major bond market turning points by about two years.
Why? Actually, I have no idea why the lead/lag relationship is so consistent, but it still makes perfect sense that there should be one. Put another way, why do changes in overnight interest rates affect the capital markets? The answer, of course, is that like a pebble splashing into a body of calm water, the ripples spread out over time through the conduit of the financial system and into the real world. While central bankers admit that it often takes 12-18 months for monetary policy changes to impact the economy, we simply suggest that major changes in the direction of longer term interest rates- either up or down- affect commodity prices as a whole two years later.
I have included charts of the U.S. 30-year T-Bond futures and the Dow Jones AIG Futures Index, and shifted them so that the lead/lag relationship can be seen more clearly. What you are looking at, then, are the broad movements of longer-term interest rates (with falling bond prices equating to rising rates) and commodity prices. Viewed in this way it is possible to see quite clearly how major peaks in the bond market (lows for interest rates) are followed about two years later by cyclical peaks in commodity prices.
Keep in mind that this is a trend within a trend. At present we are still dealing with a deflationary cycle. On the other hand, simply knowing whether the general trend within that cycle is toward rising or falling commodity prices is a significant benefit. With that knowledge you can adjust your trading strategy from selling the rallies to buying the dips. The surprises should all be to the upside through the year 2000.
2. The Bond/Stock 6-Month Lag
Have you ever wondered why so many people argue that timing the stock market is impossible? It isn’t, but it also isn’t easy. It is my view that this is actually more an art than a science, which makes it very difficult for people on Wall Street. If you realize that there is a tremendous need to ‘black box’ the market- to quantify or model it- you can get an appreciation for why so many view the movements as seemingly random. Let’s start with this: Each equity market cycle is both broadly similar and exceptionally unique. There are repeating patterns, but they occur in a different enough way that spotting them takes more than a bit of thought.
I would also suggest that the ‘buy for the long-term’ message that we have all been bombarded with over the past decade or so was created and perpetuated by the mutual fund industry, which earns a percentage on the assets under management and thus has a vested interest in having individuals ride out the declines.
In recent Humphrey-Hawkins testimony, Mr. Greenspan suggested that there was no way of knowing if there was a ‘bubble’ in the financial markets until it could be examined with the benefit of hindsight. While it is certainly not the prime function of the Federal Reserve to keep prices and underlying values close together, this comment exemplified the views of many- and was wholly incorrect. In cycle after cycle, the ‘bubble’ is created when the equity markets rise after the bond market turns down. The longer this process continues the greater the resultant risk. The higher the equity markets move in the interim, the larger the eventual market decline. If left unchecked, it has the power to destabilize the entire financial system.
To show what I mean, I have included a comparative chart of the U.S. T-Bond futures and the S&P 500 Index futures for the 1987-90 period. I could have used the Dow Jones Industrial Index or the S&P 500 Index itself just as easily.
During a deflationary cycle, all declines in the equity markets are buying opportunities UNTIL the bond market peaks and turns down. The equity markets tend to accelerate higher at that point, and usually provide the best gains of the entire cycle over the next six months. The real risk begins to build 5-7 months after the bond market peak.
I don’t, by the way, just use the bond market for this analysis. I cross-reference the bond market peak with various other markets to determine the exact starting point. I also use the utility indices (both the Dow Jones Utility Index and Philadelphia Utility Index) for confirmation. However, in a general sense the crucial message here is that once bond prices begin to fall in earnest, the equity markets tend to rise briskly to a top and then correct lower.
How is this useful?
Consider the equity market action through into 1998. Bond prices had been rising and from the point of view of certain inter-market analyses, perhaps should have peaked in early 1998. As the pressure began to build on the currencies of several SE Asian countries (Singapore, Thailand, Indonesia, Malaysia, and The Philippines) liquidity flows pushed bond prices to new highs. When the equity markets buckled, we knew that this was simply a buying opportunity- no matter how dire the outlook appeared at that time.
3. Bonds and Equities Bottom Together
On a day-to-day basis, it almost seems impossible for the equity and bond markets to bottom together. Generally one would read that the bond market gets a ‘flight to quality’ boost any time the equity markets get into serious trouble, creating the impression that these two work in opposite directions. Not true.
Using the T-Bond futures and the S&P 500 Index once again, we showcase the 1981-85 time period to make this point.
When examining the comparative chart, it is obvious that the bond and equity markets bottomed together in 1984, but not in 1981. We used this time period specifically to point out just how powerful this relationship is. The equity markets did bottom in late 1981- even though prices went lower into the late summer of the next year. The tremendously powerful surge in the equity market at that time brought prices back to the rising channel that began when bond prices bottomed. In other words, something more powerful than inter-market forces acted on the equity markets for almost one year (a serious economic recession), but once that passed, the relationships reasserted themselves.
In the current market, the sharp increase in bond prices from the beginning of 2000 is a clear divergence. The fundamental justifications i.e. a reduction of future supply and a substantial asset allocation shift away from equities, can not alter the fact that in due course bond prices will test if not exceed the lows. To truly end the cycle, bond prices will have to wash out with equity prices.
4. Crude Oil and Bonds
One of the more fascinating inter-market relationships exists between the energy complex and interest rates. Since this relationship exists on two different levels, it often appears quite confusing. On a longer-term basis, rising energy prices put upward pressure on interest rates and vice versa.
The comparative chart of the U.S. 10-year T-Note futures and crude oil futures highlights just how powerful the relationship is between these two markets- even in a technology-driven world. The peak in interest rates (bottom in bond prices) globally tends to occur when crude oil, heating oil, and unleaded gasoline futures peak for the cycle. Typically this process takes about 15 months.
In the short-term, however, there is more here than meets the eye. It may be common knowledge that rising energy prices affect interest rates, even in the absence of any discernible change in the overall inflation rate, but what is generally not known is which market drives the other. Intuitively we would think that rising energy prices are causing bond prices to fall, but in the short-term it is actually the other way around.
In the shorter-term chart of crude oil futures and T-Note futures shown below, it becomes clear that oil prices will continue to work higher until bond prices make new lows. In other words, as long as bond prices are trading above the recent lows, energy prices will keep working higher. This process will continue through the entire cycle until bond prices finally move low enough to impact both the financial markets and the economy, at which point oil prices will collapse- marking the peak in interest rates.
In summary, then, we see that rising energy prices drive interest rates higher in the medium to long term, but that relatively firm bond prices tend to push crude oil prices higher in the short-term.
5. Commodity Prices, The Dollar, and Emerging Market Equity Valuations
Even in this new age of e-commerce and technological revolution, commodity prices still matter. Many regions of the world are extremely sensitive to the pricing of basic raw material prices, although we tend to overlook the fact that from an external point of view, the U.S. dollar is also a major factor. I have found that the multiplying the U.S. Dollar Index by a broad index of commodity prices is a helpful tool in assessing the overall trend of some of the smaller equity markets. Above we show this product compared Argentina’s Buenos Aires SE Bolsa Index.
6. Commodity Prices and Sector Selection
Shown above is a comparative chart of the CRB Index futures and the price spread between the U.S.’s Dow Jones Industrial Index and Canada’s TSE 300 Index. As Canada has a much greater reliance upon commodity prices, it makes intuitive sense that its equity markets would tend to outperform once commodity prices turn higher, and vice versa.
7. Technology and Commodity Prices
Most people involved with the financial markets, in my opinion, tend to miss the bigger picture. The trend in commodity prices, for instance, affects interest rates, currencies, foreign equity markets, and commodity sensitive industries. It also has a rather marked impact on certain sectors that ordinarily wouldn’t be associated with raw material price trends. To show what we mean, we have included a comparative chart that contrasts the movement of the CRB Index futures with the price ratio between the Nasdaq Composite Index and the CBOE Internet Index (Isdex). When this ratio is falling, it means that Internet oriented companies are performing better than the Nasdaq index as a whole.
I have tried to show a number of inter-market relationships that may help in understanding the reasons behind the broad trends in some of the financial markets. At the IMRA, we prepare a daily report that covers the equity, fixed income, foreign exchange, and commodity markets. Our goal is to demystify the markets and present a clearer picture of what is happening and why. We work on identifying trend changes and explaining the likely impact that one market will have on another. As one might expect, it is quite a challenge.