Is It Time To Emphasize Commodities And Reduce Bond Exposure?

• The Six Stages
• Characteristics of Stage IV
• The stock market’s view on commodities
• All that glitters

The Six Stages

In the latest bi-weekly Market Round Up Webinar I looked at several inter-asset relationships to see which ones are likely to outperform going forward (watch the webinar here). To start with I pointed out that the business cycle is nothing more or less than a chronological sequence of events that are continually repeating. Fortunately for investors the primary turning points of bonds, stocks and commodities are part of that sequence. Chart 1 shows the growth path of a theoretical economy with the six turning points flagged by the arrows. Those turning points allow us to divide the cycle into Six Stages. These are objectively determined by our three Pring Turner models, one for each market. When all three are bullish, as they are now, that places the cycle in Stage III. Unfortunately, since the mid-1950’s this nirvana stage environment has only been in existence for 5.3% of the time. The average length of Stage III is 1.8-months. The point of the webinar was to anticipate the potential for a quick transition to Stage IV and to see whether the technical position of the markets was consistent with such a transition. You can view my recent webinar charts here.

Chart 1

I should point out that this Six Stage approach is far from perfect, as some cycles see the skipping of stages or even a retrograde, as Stage III moves back to Stage II etc. Despite its deficiencies, the Six Stages Model offers us a disciplined framework from which to work. The whole point of the exercise is to make sure that market action is consistent with stage identification, as determined by the models. As you can see from Chart 1, the next phase, Stage IV, involves the Bond model going bearish. Historically the cycle has been in Stage IV 31% of the time, the average signal having lasted for 6.5-months. Chart 2 shows that all three markets are above their 200-day moving averages, thereby confirming the models.

Chart 2

Characteristics of Stage IV

We know that the principal characteristic of Stage III is that you can throw a dart at any of the markets and they will rally for you. Stage IV begins a more selective process in which bonds enter a bear market and interest sensitive stocks face a rising rate headwind. Stocks overall, though, remain in a bull trend. If we were to calculate a ratio between stocks and bonds we would expect to see it in an uptrend favoring equities. Chart 3 compares the S&P to the 30-year bond price. Right now the picture is mixed because the ratio is above its 12-month MA but below the small green down trendline. Also, the KST is flattening, but in an undeniably bearish mode. Bearish, in this case, means that bonds are continuing to out-perform stocks. The green arrows indicate that if the KST were to rally we would expect the ratio to as well. That green trendline becomes a very important one since a move above it would signal that the trend now favored stocks. It would also set up a test of the hugely important 2000-2016 resistance trendline, the violation of which would complete a gigantic base. Bottom line, stocks are currently in a downtrend in their relationship with bonds but are certainly poised for an imminent reversal that would be more consistent with a late Stage III/early Stage IV environment.

Chart 3

Another characteristic of a Stage IV or Stage V environment is for commodities to outperform bonds. Chart 4 compares the CRB Composite to the 30-year bond. The ratio has violated a very steep down trendline. The angle of descent is so steep it’s unsustainable. That’s why I can’t get too excited, except to conclude that it probably means a dissipation of downside momentum. That is actually a nice piece of information to have since the implication would be for the tentative KST buy signal to evolve into a more decisive one. The green arrows show that reversals from zero or below have usually resulted in a nice rally. We would see a bull market for commodities against bonds start at these green arrows. Even where the signals failed as per the dashed arrows, a red price trendline violation acted as a warning that it would not. We are not quite there yet, but a rally by the ratio above its 12-month MA and the late spring intermediate high would do the trick in terms of signaling a reversal favoring commodities.

Chart 4

The stock market’s view on commodities

Chart 5 features two stock market ratios that compare inflation to interest sensitive industry groups. These are the Goldman Sachs Natural Resource/Spider Consumer Staples (IGE/XLP) and my own Inflation/Deflation ratio. As you can see, they both track the DB commodity ETF (DBC) and therefore offer the equity market’s confirming or non-confirming view of where commodity prices are headed. This week, the IGE/XLP ratio completed a 1-year reverse head and shoulders. The Inflation/Deflation ratio looks set to follow suit. If that happens I think there would be an excellent chance that the DBC would also break to the upside, thereby indicating a further extension to the commodity bull market. Remember, when commodities rally that’s usually associated with a drop in the dollar.

Chart 5

Resource-based currencies

Charts 6 and 7 add supplemental evidence to the possibility of a commodity rally. Both the Canadian and Aussie dollars are close to completing reverse-head-and-shoulder patterns. Canada needs a move above 80c for a decisive breakout and Australia 78c.

Chart 6

Chart 7

All that glitters

Finally, Charts 8 and 9 show that gold may be in the process of bottoming against stocks and bonds. Until their respective bases have actually been confirmed with a breakout we cannot be sure. However, with a plethora of indicators such as the resource-based currencies, stock market inflation/deflation ratios etc. all pointing in the same direction you can be sure that if such a breakout does develop it would likely be explosive.

Chart 8

Chart 9

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group or its affiliates.