COMMODITIES ARE THE BIGGEST FIRST HALF WINNERS -- LONG-TERM TREND FAVORS STOCKS OVER BONDS -- RISING COMMODITIES MAY HELP STOCKS, BUT ARE BAD FOR BONDS -- RISING COMMODITIES BOOST ENERGY AND MATERIAL STOCKS
COMMODITIES AND STOCKS WERE TOP FIRST HALF PERFORMERS... With the first half of the year coming to a close, it's a good time to study the relative performances of the various asset classes. Chart 1 shows that commodities and stocks were the two biggest gainers -- and in that order. The CRB Index (of 19 commodity markets) gained 10% during the first six months of the year, versus a 6% gain in the S&P 500. 10 Year Treasury bonds gained ground but at a slower rate of 2%. The U.S. Dollar Index fell -0.26% during the first half, which largely explains the strong commodity performance. We're going to delve deeper into the relative performances of stocks, bonds, and commodities. Their relative performance tells us not only which asset classes to favor. But they also tell us something about the state of the business cycle and which market sectors to favor. They may also tell us which foreign markets may start to reap the benefits from rising commodities.
Chart 1
STOCK/BOND RATIO FAVORS STOCKS ... Let's start with the relationship between bonds and stocks because it's probably the most important. I've covered this in a couple of recent market messages, but will review it again today. The black line in Chart 2 is a "relative strength ratio" of the S&P 500 divided by the "price" of the 30 Year T-bond ($USB) over the last decade. The stock/bond ratio showed a falling trend (between parallel trendlines) from 2000 to 2013. Major peaks during 2000 and 2007 were caused by the start of major bear markets in stocks, which also saw rising bond prices. Ratio bottoms in 2003 and 2009 were caused by major upturns in stock prices (and the selling of bonds). The trend since 2009 has favored stocks. During 2013, however, the ratio exceeded the resistance line drawn over 2000/2007 highs and signalled that the decade of bonds was over, and that the long-term asset allocation pendulum now favored stocks. The black circle shows that the ratio consolidated during the first half of 2014 within that uptrend. The upper green line shows the "ratio" of the S&P 500 divided by the 10-Year T-Note ($UST) already climbing to the highest level in 14 years. That suggests that the black line in Chart 2 will likely hit a new high as well. Both ratios in Chart 1 strongly suggest that stocks are now the preferred asset class, and are likely to remain so for some time. Which brings us to the relationship of stocks to commodities.
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Chart 2
COMMODITIES ARE STARTING TO RISE WITH STOCKS... Chart 3 compares the trend of the S&P 500 (black bars) to the CRB Index (shaded area) over the last decade. Generally speaking, a positive correlation existed for most of the time since 2000. Stocks and commodites fell between 2000 and 2002 during a bear market and recession. They rose together between 2003 and 2007. Stocks peaked in 2007 and commodities in 2008. [Commodities usually peak after stocks]. Both fell sharply during the second half of 2008 during another bear market and recession. They bottomed together during 2009 and rose together until 2011 when they started to diverge. Stocks rose between 2011 and 2013 as commodities dropped. During 2014, however, commodities have started to rise. The brown line on top of Chart 4 is a "ratio of the S&P 500 divided by the CRB Index. It shows that stocks underperformed commodities between 2000 and 2008, but that the trend has favored stocks since then. The fact that commodities are starting to rally during 2014 carries good news for both. Rising commodity prices are early indicators of inflation. That's usually good for stocks and the economy since it allows for greater pricing power and implies growing economic strength. [Commodity prices also have a history of turning up after stocks]. Commodity strength also carries good news for stocks tied to commodities. Unfortunately, it carries bad news for bonds.
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Chart 3
COMMODITIES ARE GAINING ON BONDS... Chart 4 compares the CRB Index to the price of the 30-year T-bond over the last decade. Historically, they usually trend in opposite directions. That's because rising commodity prices imply higher inflation which is usually bad for bonds. That hasn't always been the case over the last decade, largely owing to the Fed's policy of keeping bond yields at artificially lower levels and bond prices unusually high. Their negative correlation, however, can still be found in Chart 4. For example, commodities fell and bond prices rose between 2000 and 2002, and again during 2008. Rising commodities between 2002 and 2008 caused bond prices to flatten. Bonds weakened during 2009 when commodities turned up. Falling commodities coincided with firmer bond prices during 2011. The CRB/bond ratio on top of Chart 4 gives a clearer picture of their relative performance. Bonds did better between 2000 and 2002, and again during 2008. Commodities did better between 2002 and 2008. Bonds also did better during 2011. The ratio, however, is rising during 2014 as commodity prices firm. That favors commodities at the expense of bonds. That situation could become more serious later in the year if rising inflation pressures coincide with the end of the Fed's buying of Treasury bonds. Relative strength analysis suggests that commodity assets are likely to be a a stronger bet than bonds.
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Chart 4
RISING COMMODITIES HELP MATERIALS AND ENERGY ... Chart 5 is intended to show that the direction of commodity prices impacts the relative performance of stocks tied to commodities. The gray line plots a "ratio" of the Materials Sector SPDR (XLB) divided by the S&P 500. The black line is a ratio of the Energy SPDR (XLE) divided by the SPX. At least two things can be seen on the chart. Both relative strength lines usually trend in the same direction. And secondly, both lines tend to rise and fall with the trend of the CRB Index (solid area). All three lines have risen during the first half of 2014. As explained earlier, the CRB Index rose 10% during the first half, making it stronger than stocks and bonds. At the same time, energy and material stocks gained 14% and 7% respectively to outpace the S&P 500 gain of 6%. That trend is likely to continue as long as commodity prices keep rising. Rising foreign currencies are also positive for commodity assets.
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Chart 5
COMMODITY CURRENCIES LEAD RALLY AGAINST DOLLAR... Another side effect of rising commodities is that it boosts foreign markets that produce commodities -- like Australia and Canada. Their currencies also get a added boost when rising commodity prices are combined with a weaker dollar. As already mentioned, the Dollar Index lost -0.26% during the first half of the year. Two of the strongest currencies have been tied to commodities. The brown line in Chart 6 shows the Australian Dollar gaining 5.7% during the first half, making it the strongest of the major foreign currencies. The rising red line shows the Canadian Dollar gaining 3.6% during the second quarter, which made it the strongest foreign currency against the U.S. currency. I believe their strength is tied to the stronger commodity trend. That's also helping Australian and Canadian stocks.
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Chart 6
AUSTRALIA AND CANADA ETFS HIT NEW RECORDS... Right on cue, Australian and Canadian stocks are doing a lot better -- both on an absolute and relative basis. The solid line in Chart 7 shows Australian iShares (EWA) ending the week at a new record closing high. Its relative strength (dashed) line has started rising during 2014 versus EAFE iShares (which includes foreign developed markets in Europe Australasia and the Far East). Chart 8 shows Canadian iShares (EWC) reaching a new record closing high as well. Its relative strength line (dashed line) is also doing better than EAFE iShares. Canadian and Australian iShares gained 11% and 10% respectively during the first half (as commodities rallied). Both commodity exporters outpaced the S&P 500 and EAFE iShares which rose 6% and 4.3% respectively. There again, I suspect that rising commodities are the main reason why their stocks (and currencies) are doing better this year. The same may be true of some emerging markets that produce commodities.
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Chart 7
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Chart 8
BRAZIL LEADS EMERGING MARKET REVIVAL... Rising commodity prices may benefit one other asset class -- emerging markets. Many of the biggest emerging markets are tied to commodities either as importers (China) or exporters (Brazil and Russia). Chart 9 shows Emerging Markets iShares (EEM) moving above the highs of last spring and autumn. The dashed line is a "ratio" of the EEM divided by EAFE ishares. The rising ratio shows the emerging markets have done better than developed markets this year for the first time in awhile. [The EEM outdid the EAFE during the first half by a modest margin of 4.5% to 4%. Since March, however, the EEM gain grew to 10%, nearly double the EAFE gain of 5.4%]. Not surprisingly, Brazil was one of the biggest 2014 EEM winners. Brazil is a big exporter of commodities. The weekly bars in Chart 10 show Brazil iShares (EWZ) breaking a resistance line extending back to 2011 (when commodities peaked). It is also challenging its October high near 50. Brazil iShares gained 9.8% during the first half of the year, which is double the EEM gain. [It was beaten only by India's gain of 19%]. Its currency is rising as well. The green line on top of Chart 10 shows the WisdomTree Brazil Real Fund (BZF) rising to the highest level in five months. When investors buy foreign stocks, they have to also buy the currency. The Brazil currency rose 12.7% during the first half, outpacing the Aussie and Canadian Dollars. I believe the 10% commodity gain (and the weaker dollar) during the first half also had a lot to do with that.
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Chart 9
