A REVIEW OF THE NEW NORMAL IN INTERMARKET RELATIONSHIPS -- BONDS AND STOCKS TREND INVERSELY -- STOCKS AND COMMODITIES TREND TOGETHER -- THE MAIN REASON FOR THE CHANGES IS THE DEFLATIONARY ENVIRONMENT OVER THE LAST DECADE
INTERMARKET REVIEW... Over the weekend, Chip Anderson reviewed the Intermarket Picture based on the "normal" relationships that have worked for decades in the financial markets. Some of them, however, have changed in recent years (as we've pointed out in our market messages). Those intermarket changes, and the reason for them, were explained in my second book on Intermarket Analysis published in 2004. The main change had to do with the way bonds and stocks interact. I wrote a market message on that subject last June (and have used that as my guide in subsequent messages since then). The following paragraph is a repeat of that earlier message. The second change that took place due to deflation pressures over the last decade has been the positive correlation between stocks and commodities. I've also used that as my guide over the past few years. I'll quote from my second Intermarket book to explain why that happened and is still happening today. As a result, there's a "new normal" in some intermarket relationships. While those newer relationships are the current norm, some of them could change at some point in the future. One of the factors that could cause that to happen would be a serious burst of inflation. I'll end up with a discussion of the possible threat of stagflation which could occur if and when inflation becomes a reality and deflation fears recede into history. And why current Fed policy may be leading us in that direction.
"LINK BETWEEN BONDS AND STOCKS CHANGED IN 1998 (MARKET MESSAGE, JUNE 24, 2010)... In my 1991 intermarket book, I wrote that bond and stock prices generally trended in the same direction. That meant that bond yields and stocks trended in opposite directions. In the three decades between the 1970s and 1990s, falling bond yields were good for stocks. As my second (2004) intermarket book pointed out, however, the bond/stock relationship changed during 1998 as a result of the Asian currency crisis and the onset of global deflation. In fact, it was the change in the bond/stock relationship that prompted me to write the second intermarket book. Chart 1 compares bond yields (green line) to the S&P 500 from 1993 to 2003. Before 1998, you can see the two lines trending in opposite directions. Prior to 1998, falling bond yields (rising bond prices) were bullish for stocks. Starting in the fall of 1998, however, that relationship changed. Bond yields rose with stocks during 1999 and then tumbled with stocks during the 2000-2002 bear market. That new relationship has lasted throughout the last decade. Chart 2 shows stock prices and bond yields pretty much rising and falling together over the last ten years."
Chart 1
Chart 2
RISING BOND YIELDS ARE NOW GOOD FOR STOCKS... Chart 3 shows the positive relationship between stocks (price bars) and bond yields (green line) since the 2009 bottom. After falling together throughout 2008, bond yields and stocks turned up during the first quarter of 2009 and rose together until the first quarter of 2010. After dropping together that spring, stocks turned back up in late summer. Bond yields starting rising shortly thereafter and continue to rise along with stocks. Rising bond yields are a sign of a strengthening economy. Bond "prices", which trend in the opposite direction of bond "yields", peaked last autumn and have been falling since then. Chart 4 shows the inverse relationship between stocks (price bars) and the price of the 10-Year T-Note (green line) since last November. The collapse in bond prices coincided with the Fed's announcement of QE2 which weakened the Dollar and pushed commodity prices higher. Rising inflation expectation are also pushing bond prices lower and yields higher. Both of those factors are positive for stocks.
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Chart 3
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Chart 4
STOCKS AND COMMODITIES ARE RISING TOGETHER ... Another "normal" intermarket relationship that has changed is the more recent positive correlation between stocks and commodities. Chart 5 shows both markets falling together during the deflationary scare of 2008 and then turning up together during the first quarter of 2009. Both are now hitting new recovery highs. There's a reason for that. The 2008 price collapse in stocks and commodities caused comparisons to the depression of the 1930s. Ben Bernanke is a student of that era and took steps to prevent another deflationary spiral. He used the same playbook that FDR used during the 1930s. FDR devalued the dollar and took us off the gold standard. That caused gold (and other commodity prices) to rise in an attempt to reflate the US economy. Stocks rose along with commodities as deflation fears ebbed. (Sound familiar?) Here's how I described that scenario in my 2004 Intermarket book:
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Chart 5
"STOCK AND COMMODITIES BOTTOM TOGETHER IN 1932" ... "When deflation is the main threat, stocks and commodities become closely correlated. These two peaked together during 1929; they both bottomed together three years later (during 1932)...Both then rose together for several years. In a deflationary climate such as existed during the early 1930s, rising commodity prices are considered a plus for stocks and the economy. A rising stock market suggests that economic trends have also seen their worst." (Intermarket Analysis, 2004, p. 191).
If you consult John Murphy's Intermarket Study on this site, you'll see four lines which show the direction of the four asset classes. You'll see bond prices and the U.S. Dollar falling while stock and commodity prices are rising. That's a healthy combination for an economy that's recovering from the threat of a deflationary depression. The following interpretation is what you'll see below that PerfChart to explain how to interpret the four lines. It's been updated to reflect the "new normal" in intermarket relationhips.
PERFCHART: JOHN MURPHY'S INTERMARKET STUDY... Intermarket Technical Analysis is the study of the relationships between the four major financial markets: Stocks, Bonds, Commodities and Currencies. There are several key relationships that bind these four markets together. These relationships are:
* The INVERSE relationship between commodities and bonds
* The INVERSE relationship between bonds and stocks
* The POSITIVE relationship between stocks and commodities
* The INVERSE relationship between the US Dollar and commodities
POSITIVE: When one goes up, the other goes up also.
INVERSE: When one goes up, the other goes down.
NOTE: Although these newer relationships should be helpful in making current asset allocation decisions, they may be subject to change at some point in the future. The biggest threat to their continuance would be a serious bout of inflation which would cause the Fed to start raising short-term rates to keep pace with rising bond yields. That could hurt stocks and, in time, could cause stocks to weaken as commodities keep rising. Chart 6 shows the CRB Index peaking in mid-2008 which was more than six months after stocks peaked. During the first half of that year, commodities rose as stocks fell. That's normal since commodities usually peak after stocks. With deflation fears receding, a new threat is the type of stagflation reminiscent of the 1970s which experienced a weak dollar, rising interest rates, higher inflation, and a flat economy and stock market. Along those lines, today's final paragraph is a reprint of an article that I wrote on that subject a month ago.
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Chart 6
DON'T THE 1970'S QUALIFY AS RECENT HISTORY (MARKET MESSAGE, MARCH 1, 2011)... After reading the comments by Mr. Bernanke before Congress today, I got to wondering about how much he actually knows about market and economic history. The head of the Fed is generally acknowledged to be an expert on the Great Depression of the 1930s and government efforts to stem deflation. It seems that's been his working model since the last economic crisis that started in 2007. I'm beginning to wonder if he's working from the wrong economic model and wrong time period. He said today that experience with (commodity) price gains in recent decades, along with currently stable labor costs, suggests a "temporary and relatively modest increase in U.S. consumer price inflation". Here's my question. Doesn't the decade of the 1970s qualify as "recent" experience? I remember that decade very well having had the good fortune to be a commodity trader. The decade started with huge commodity price spikes that lasted until 1980. Those price increases were accompanied by a falling dollar, flat to weak stock prices, and rising interest rates. Inflation rose to double digits. The unemployment rate rose from 4% in 1970 to 9% in five years and ended the decade above 10%. That economic environment characterized by rising inflation, high unemployment, and a generally flat economy is called "stagflation". The fed funds rate tripled from 4% in 1972 to 12% two years later even as the employment situation worsened. Mr. Bernanke's depression model suggests that inflation is not likely while there's a weak labor market. The period of the 1970s seems to contradict that economic view when we saw both rising inflation and rising unemployment. Maybe it's time for the Fed to stop relying exclusively on the "deflationary" model from the 1930s and at least consider the possibility that the current situation might more closely resemble the stagflation period of the "inflationary" 1970s. Otherwise, the Fed risks actually re-creating the conditions that could contribute to a period of stagflation with rising inflation and a stagnant economy.
