Intermarket Analysis - Mid-Year Update 2002

Since my last research memo on May 1, 2002 on the “de-coupling” of the U.S. bond and equity markets since 1999, I have gone back and researched intermarket relationships. The inverse move in U.S. stocks and bonds has perplexed me. The relationship between these two markets is, historically, positive (i.e., they move in the same direction). I made note that perhaps, we would see a continuation of the de-coupling. Since the normal pattern is a positive correlation I decided to examine the interrelationships between the various markets with the idea that the current market action here in the United States and around the world should be examined, leading to an explanation of the de-coupling in our U.S. market. Upon examination, I hope to draw some likely scenarios going forward that may aid us in our U.S. equity selection for this coming year. I will make note of possible themes we might see going forward.

I believe we cheat our analysis and ourselves if we do not focus on the interrelationships between markets. If we try to analyze the U.S. equity market without viewing our bond market or the other markets related to stocks and bonds then we ignore the components that make up the larger view and their relationships to one another. The following are a summary of key intermarket relationships given by John Murphy in his book, Intermarket Technical Analysis (Wiley: 1991):

1. All markets are interrelated.
2. No market moves in isolation.
3. Chart action in related markets should be taken into consideration.
4. Technical analysis is the preferred vehicle for intermarket work.
5. Intermarket analysis adds a new dimension to (market) analysis.
6. The four key sectors are currencies, commodities, bonds and stocks.
7. The U.S. dollar usually trends in the opposite direction of the gold market.
8. The U.S. dollar usually trends in the opposite direction of the CRB index.
9. Gold leads turns in the CRB Index in the same direction.
10. The CRB Index normally trends in the opposite direction of the bond market.
11. Bonds normally trend in the same direction as the stock market.
12. Bonds lead turns in the stock market.
13. The Dow Utilities follow the bond market and lead stocks.
14. The U.S. bond and stock markets are linked to global markets.
15. Some stock groups (such as oil, gold mining, copper and interest-sensitive stocks) are influenced by related futures markets.

It appears that the SP500 has made its first significant sign of a trend reversal since October of 2000. On a weekly chart of the SP500 (SPX) our signal is the arithmetic trend line cross (10/30 MA) in the week of January 18, 2002. This sign is preliminary but I believe, more than anything else, it shows the SPX reaching the beginning of an accumulation phase since it turned from distribution to a markdown phase on October 27, 2000. This supports a “trendless” market scenario going forward, since it will take time to build a base before the next bull cycle.

Yet, the bond market index, as reflected by the Dow 20 Bond Index (BTW), has flashed its first sell signal, since the arithmetic trend line cross on August 4, 2000. Note that in both instances, the move in opposite directions around the same time, relatively speaking. Because these two markets moved in opposite directions does not mean we can say for sure whether they will respond again, equally, in kind. So, let us further explore the relationships between these two markets given our outline from John Murphy’s work we cited from our list on the first page.

The current scenario on the landscape is thus:
1. The SP500 is currently around 1090 and has tested the 950 area since breaking above it in February 1998. The two significant tests came with the 1998 Asian/Russian/South American debacles and most recently with 9-11.
2. The two current peaks in the U.S. Bond market have come on these two dates, as well. It is interesting to note that “uncertainty” can be positive for bonds, since it is perceived as a place to go for safety, yet, the peak in bonds on these two occasions came almost exactly at the same time as these two disasters.
3. Commodities (CRB Index) started its last rise in July 1999, coinciding with Greenspan raising interest rates, and peaked the week of October 13, 2000, two weeks before sell signals (10/30 MA cross-over and ADX/DMI). It reached its most recent low in October of 2001, six weeks after 9-11 and has been moving up since.
4. Gold (XAU) has been moving up since Q2, 2001, which started its accummulation phase. Gold is currently being marked up and stands at 77.50 on the XAU. Its bottom can be pinpointed to November 2000, one month after our sell signals on the SP500.
5. The U.S. Dollar (UDX) has recently hit a high (twice) from its most recent low in April 1995, the start of the last Bull run to October 2000. Since its 1985 high of 165 it has retraced higher exactly 50% (key technical resistance) from that 1985 high to the 1992 low at 78. The dollar trades at 114.00.
6. The Dow Jones World Index (DJW) and the Morgan Stanley European Index (EUROP) gave simultaneous preliminary trend reversal signals to an accummulation phase the weeks of January 18 and 25, 2002. Both of these indices peaked at the height of the U.S. Technology Bubble (mid- March, 2000). Their sell signals came two months later in May 2000 with the 10/30 MA crossovers.

Let us now go back to our checklist on the first page and note the similarities and the differences as we study the current scenario on the world stage given our current status on the markets (1-6, above).

Looking at points 4, 6, and 14 specifically, we will examine the interrelationships between stocks, bonds, commodities, gold, the U.S. dollar and the global markets by examining the current status in points 1-6.

Starting at point 7: The U.S. dollar usually trends in the opposite direction of the gold market.

Since October of 2000, the U.S. dollar has been exhibiting distribution at the 120 levels. This date coincides with the downturn of the U.S. equity market (SP500). Although bonds have NOT turned down with the SP500, relative to the XAU (Gold), bonds have moved in the opposite direction since November of 2000. The linkage between the U.S. dollar and gold has held true. The recent strong up move in gold has coincided with the down move in the U.S. dollar. Should this continue we could expect the move in the U.S. dollar to be lower. If there appears to be corroborating evidence from the other markets to support this linkage, we may have a better idea of where to position ourselves relative to the equity market. We have hit a pivot point at 80 on the XAU and this represents resistance in the short-term. I expect gold to go higher (first target 90) in the longer term as the commodity index rises, also.

Point 8: The U.S. dollar usually trends in the opposite direction of the CRB index.

The dollar has trended in the opposite direction of the CRB from October 2001 to the present. The dollar, relative to the CRB has gone up, while the CRB Index has gone down. Since February 2002, these two markets continue to move in opposite directions, only now, the U.S. dollar is FALLING while the CRB Index is RISING. I expect this trend to continue in the long run as global markets recover.

Point 9: Gold leads turns in the CRB Index in the same direction.

This is happening now. Gold made its first good move in May of 2001, at a time when the CRB was flat. Gold broke through the May 2001 resistance in February of 2002. February 2002 marked the coinciding move in the CRB with gold. Gold lead the CRB in May of 2001, and then the CRB started moving, as well, in February 2002.

Point 10: The CRB Index normally trends in the opposite direction of the bond market.

The bond market’s recent sell signal occurred on January 18, 2002, while the turn up in the CRB index flashed buy (10/30 MA) the first week in March, 2002. So, within six weeks we have corroborated the move supporting Point 10, an inverse relationship between these two market components. The CRB is moving up while the bond market is moving down.

Point 14: The U.S. bond and stock markets are linked to global markets.

The question becomes, exactly how are they linked? We read in #6 under the current scenario that the European and World Markets followed the U.S. equity market down in March and May of 2000. Both global indices rose with the U.S. equity market from 1995 to 2000. There appears to be a positive correlation. Where the U.S. market rallied back from the April 2000 low to the August 2000 re-test, in an attempt to “believe” things were fine, Europe and the World knew better, continuing lower. This “de-coupling” by foreign investors back then, leads me to believe that the global markets will turn up ahead of our domestic markets; nay, at the expense of our domestic income components, the U.S. dollar and U.S. bonds. This trend is showing up now.

Since the perceived collapse of the global markets in October 1998 there has been a flood of money into the U.S. markets from abroad. Some analysts cite the great bull market from 1995 to 2000 in U.S. equities as a fleeing from the likes of Japan and other foreign money to a safe haven in the U.S., hence, the inflow of foreign money that took the U.S. markets to dizzying heights. I happen to agree with that assessment. The perception has been that the U.S. is the only place to put one’s money given the economic and political risks on the global stage. This may support the reason why the U.S. bond market has NOT gone down in tandem with the US equity market since Q1, 2000. It is at this time we see the “de-coupling” of the usual positive relationship between U.S. bonds and equities. But, note that the bond market has NOT gone up significantly, rather, it has been moving sideways from Q3, 2000 to Q1, 2001 and is now lower.

Foreign money has been “stored” in America through the U.S. bond market. But where does this leave us now?

European and world equity markets have started to turn up recently relative to the U.S dollar and the SP500. International markets have seen good times since last year. This may suggest that Europe and the World are leading the way out of the economic malaise we have experienced on the global stage since late 1998.

As the global markets turn up, this will catch the eye of “ big money.” Money Flow will move to lower valuations, hence, perceived lower risk with the hopes of higher return. The U.S. markets are “over valued” by historical standards and money is trying to find other venues. The recent “re-designation” of price-to-earnings by Standard and Poor’s, is an effort to properly value the current market. For example, a truer representation forces companies to reflect components such as options given to employees, thereby decreasing earnings. Also, a redesignation of “goodwill” does not allow companies to inflate its earnings over a longer period of time. Standard and Poor’s has adjusted its P/E multiple up to 41, twice-historical all-time highs. This may result in a reversion back to historical yields, higher than they are now. For old timers that remember the significance of dividends and yields, an historical representation of yield at 3.0% puts the SP500 at 549 and the DJIA at 6173. The Federal Accounting Standards Board (FASB) has instituted stricter standards on U.S. corporations regarding their reporting. These newer, truer standards will continue to suppress money flowing into the U.S. equity markets as investors realize “true” valuations. With a large amount of foreign money already stored here domestically, how long will it continue to rest in our coffers? A harder scrutiny of our domestic markets in the light of the 2000 Bubble and the recent accounting shenanigans will give pause for all investors as we continue to scratch our heads trying to determine the “reality” of balance sheet fundamentals. These new policies and this shift in psychology will ratchet down investment in the years to come as the United States builds a base in an accummulation phase before the next bull market arrives.

The flow of money into the global markets has started since the U.S. decided to respond to 9-11. The global markets may be saying, “Yes, there may be skirmishes around the world, but the present U.S. Administration will use its technology to eradicate the world of terrorism, no matter what it takes (until the end of the Bush administration, anyway). Let the U.S. handle it, and let them clean up the world of evil as they protect us. Let’s get back to business and let them worry about it. We need to get back on our feet and get some money back into our recession torn economies. Maybe, we will even take some of our money out of the U.S. and invest in it in our own country.”

If bonds lead the stock market, it should follow that equities should continue lower. It is here that I am going to buck what “should happen.” I do not see a collapse in the U.S. equity market, as seen in the SP500. I see an accummulation phase lasting many years. Specifically, as I have mentioned in other memos, this could mean the SP500 moving back to the Asian Contagion lows of 1998 at around 884 (down 15%-20% from here), which would still put us in our “trendless” building phase. We saw 950 in September 2001. The move to the 900 area is a solid 61.8% retracement from the start of the 1995 bull market to the 2000 peak and would represent a second move to that level which means the removal of more excess. This important retracement level and support zone, coupled with the recovery around the globe will help stabilize the U.S. market. The U.S. will participate, although lagging, in the global recovery.

When money flows out of the U.S. markets, our dollar will fall. The gradual rebuilding in foreign lands will lead to a rise in pricing and competition for money. Central Banks around the world, like ours, are sitting on very low rates of interest. The global economies will grow with the greater monetary inflow. The lower dollar will make our multinationals look more attractive. The U.S. will still be producing and the world can buy our goods and services at a price a lot lower than now. This will IMPROVE the balance sheets of the bigger multinationals and U.S. companies that provide material and services for a global recovery. In other words, there will be select Industry Groups in the U.S. economy that will benefit from the recovery. Ultimately, this will spark the United States economy.

The CRB, which is representative of the rise in pricing is already in an accummulation/markup phase and will move higher. The CRB will continue higher as the world demand for commodities increases. Gold, a leading indicator of the CRB has already moved up over the last twelve months. Notice that the time frame for these relationships may not be instantaneous or within a few months. In the case of gold and the CRB, it took time for that move to take place.

The dollar is trending down, due to the above factors, and is in line with the perception that rising prices are ahead. In the U.S., after 11 rate cuts, where are interest rates headed while they sit at less than 2%? I think up, eventually. Along with the dollar, bonds, which move opposite of rising rates are heading lower. They have exhibited distribution for the past 5 quarters and are moving lower at this time. The move down in bonds correlates historically with the opposite move in commodities (CRB Index), which is moving higher, gradually.

Conclusion:

As the global markets turn up, the competition for money and material will rise. Since the extended worldwide recession dating from 1998, we have seen financial markets in Asia, Russia and South America fall. Japan admits to a banking crisis and the United States had a financial debacle in the burst of the dot.com bubble, leading to trillions of dollars lost. Along with everyone losing a good part of their money here and abroad, the bad guys held up the train, also (terrorism). Can it get any worse? Who knows? But what the global markets are saying now is, “ we have had enough. Sure there are problems, but it is time to move on.” This “moving on” event, combined with the aforementioned intermarket relationships, will produce an accummulation phase in equities around the world.

Given the above scenario, let us concentrate a portion of our equity buying, going forward, in the areas that will benefit from a global recovery and its implications. Coupled with our proven, value oriented philosophy we should be able to weather any fluctuations as the U.S. equity market finds its footing in the accummulation phase, our “trendless” base building process, going forward.

Recommended Industry Groups for Equity Purchases:

Commodity and building related – rebuilding the globe will take earth-moving equipment. Building new hovels will take building equipment. Buildings will need wiring like copper, as well as bricks and mortar that can be provided by manufacturers. Pipefittings, toilets and other manufactured items we take for granted will be needed.

Energy - Natural and man-made power to generate comfort will be needed for the buildings and structures created and for the vehicles that move earth and tear down the old walls. Drinking water will be needed.

Agriculture and Chemical – While people are building, they will need food and places to grow food. Their new found independence as a result of making life better for themselves will motivate them in learning how to grow their own food. Chemical and farming technology will provide the answers. Irrigation will be needed.

Communications – As countries work within and outside their boarders, they will need to talk to one another, which they will learn, will lead to greater efficiency. In time, this will stimulate the creation of greater technologies.

These are a few ideas. I have covered some broad sectors: basic materials, energy, capital goods, technology, transportation, and food.

United States industry supplies many of these goods and services. Maybe we should concentrate on these areas and find the best stocks within these groups?

Carl Perthel
May 17, 2002

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