Reliable Long-Term Ratio May Be About to Trigger its Seventh Buy Signal for Stocks Since 1995
Sometimes, it's a good idea to approach likely market action not so much from an analysis of the market itself, but substituting intermarket or interasset relationships to accomplish the same objective. It is a fact that each business cycle goes through a set series of chronological sequences. We know this best from the publication of leading coincident and lagging indicators, which get their name from the fact that certain areas of the economy, such as housing starts, lead us out of recession, while others, such as capital spending, prosper in the more mature phase of the recovery. The great thing about all this is that the primary trend turning points for bonds, stocks and commodities are part of this chronological sequence. Specifically, stocks respond to swings in the economy about 90% of the time. Two notable exceptions developed in 1926-27, when a major sell-off was avoided despite a recession. The second was in November 2001, when prices continued to drop for 11 months following end of that recession. Monitoring the 12-month MA would have kept you in stocks in 1927 and out of them in the 2001-02 period.
Figure 1 shows an idealized economic growth path, with the theoretical peaks and troughs of the financial markets. Bonds usually bottom after the recession has gotten underway. Stocks reach their low point later, as market participants begin to realize that higher bond prices (lower yields) are going to have a positive effect on the economy.
In that respect, Chart 1 compares the performance between stocks and bonds. It shows that, in reality, the nice-looking connection between them in Figure 1 is not always helpful. Yes, bonds do have a tendency to lead stocks at major tops and bottoms, but the leads and lags vary. Also, the 2009 stock market bottom was accompanied by a bond market peak.
Chart 2 takes us a step further by comparing stocks to the ratio between stocks and bonds. This arrangement, whilst not perfect, does offer a more cyclic feel akin to Figure 1. It may be informative using the benefit of hindsight, but, from a practical point of view, this relationship is not offering much in the way of actionable signals going forwards.
That's where Chart 3 comes in, as it's possible to construct a series of trendlines for both the S&P and the ratio. Violations are typically followed by an important change in the direction of the stock market. Note that the last few years have been periods of consolidation for the ratio. That suggests that, if it can break above the horizontal green resistance trendline, a long-term durable rally will follow for both series.
A more objective and arguably reliable approach is to calculate a long-term momentum curve for the ratio such as the KST. Chart 4 shows that positive MA crossovers by this highly cyclic indicator are then used as buy signals for the stock market. The chart tells us that all six previous signals were followed by a long-term equity rally. In that respect, the thick arrows point up cycles that experienced a recession, whereas the thin ones reflect four slowdowns in the growth rate of the economy. Slowdowns occur where the economy's growth rate decelerates, but not sufficiently to result in a recession. Note that the two recession associated signals were followed by the longest and strongest advances.
The KST has yet to experience its 2020 recession-associated buy signal, but the latest uptick suggests that it may not be that far away.
So too does Chart 5, which compares the ratio to its Special K, which you can read about here. The thick arrows point up that this indicator typically peaks and troughs around the same time as the ratio. Consequently, when it is possible to construct a 9-month or longer trendline against the Special K, its penetration invariably signals a reversal in the prevailing primary trend. Currently, the indicator is just below its 2019-2020 down trendline. It's an important one not just because of its length; it's also been touched on five occasions, which makes it a significant level of dynamic resistance. Consequently, its violation would very likely be followed by a new all-time high in the ratio.
Chart 6 shows that this is likely to happen sooner rather than later, as the ratio has just experienced a daily KST buy signal.
In addition, we can see from Chart 7 that the S&P itself has just completed a small reverse head-and-shoulders at a time when its 12-day ROC has just broken above a 6-month down trendline. A similar price/momentum breakout signaled an end to the June/July correction, so it's very likely that we will see a similar outcome going into the seasonally bullish year-end period. Remember, you can update these charts going forward by simply clicking on them.
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 Groupof Walnut Creek or its affiliates.
