If You Can't Be With The Stock You Love, Love The Stock Your With!! (ci)
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Stage 1 shows the economy contracting and bonds turning up as interest rates decline. Economic weakness favors loose monetary policy and the lowering of interest rates, which is bullish for bonds.
The first three stages are part of an economic contraction (weakening, bottoming, strengthening). Stage 3 shows the economy in a contraction phase, but strengthening after a bottom.
This cycle map is based on one shown in the Intermarket Review by Martin J. Pring (www.pring.com). The business cycle is shown as a sine wave.
Business Cycle
The graph below shows the idealized business cycle and the intermarket relationships during a normal inflationary environment.
Put another way, the consumer staples sector outperformed the consumer discretionary sector. Also notice that this ratio peaked ahead of the S&P 500 in 2007 and broke support ahead of the market. The ratio bottomed ahead of the S&P 500 in late 2008 and broke resistance as the S&P 500 surged off the March 2009 low.
The chart above shows this ratio with the S&P 500. The ratio was rather choppy in 2004, 2005 and 2006. A strong downtrend took hold in 2007 as the consumer discretionary sector underperformed the consumer staples sector.
Chartists can compare the performance of these two with a simple ratio chart of the Consumer Discretionary SPDR (XLY) divided by the Consumer Staples SPDR (XLP).
Stocks in the consumer staples sector represent products that are necessary, such as soap, toothpaste, groceries, beverages and medicine. The consumer discretionary sector tends to outperform when the economy is buoyant and growing. This sector underperforms when the economy is struggling or contracting.
Stocks in the consumer discretionary sector represent products that are optional. These industry groups include apparel retailers and produces, shoe retailers and produces, restaurants and autos.
Staples/Discretionary Ratio
Chartists can also compare the performance of the consumer discretionary sector to the consumer staples sector for clues on the economy.
Bonds decline under these circumstances and rise when the economy is weak and/or deflationary pressures are building. A ratio of the two can provide further insights into economic strength/weakness or inflation/deflation.
Industrial metals and bonds rise for different reasons. Metals move when the economy is growing and/or when inflationary pressures are building.
As a result, chartists can watch industrial metals prices for clues on the economy and the stock market. Rising prices reflect increasing demand and a healthy economy.
A price rise due to a supply shock is negative for stocks, but a price rise due to rising demand can be positive for stocks. This is also true for industrial metals, which are less susceptible to these supply shocks.
Industrial Metals and Bonds
Not all commodities are created equal. In particular, oil is prone to supply shocks. Unrest in oil producing countries or regions usually causes oil prices to surge.
Bonds benefit from a decline in commodity prices because this reduces inflationary pressures. Stocks can also benefit from a decline in commodity prices because this reduces the costs for raw materials.
Countries with weak economies and big debt burdens are subject to weaker currencies. A rising Dollar puts downward pressure on commodity prices because many commodities are priced in Dollars, such as oil.
What are the effects of a rising Dollar? A countries currency is a reflection of its economy and national balance sheet. Countries with strong economies and strong balance sheets have stronger currencs.
Obviously, a big advance in commodities would be bearish for bonds. By extension, a weak Dollar is also generally bearish for bonds. A weak Dollar acts an economic stimulus by making US exports more competitive. This benefits large multinational stocks that derive a large portion of their sales overseas.
Dollar and Commodities
While the Dollar and currency markets are part of intermarket analysis, the Dollar is a bit of a wild card. As far as stocks are concerned, a weak Dollar is not bearish unless accompanied by a serious advance in commodity prices.
The list below summarizes the key intermarket relationships during a deflationary environment.
An INVERSE relationship between bonds and stocks
A POSITIVE relationship between interest rates and stocks
An INVERSE relationship between commodities and bonds
A POSITIVE relationship between commodities and interest rates
A POSITIVE relationship between stocks and commodities
An INVERSE relationship between the US Dollar and commodities
A rise in bond prices and fall in interest rates increases the deflationary threat and this puts downward pressure on stocks. Conversely, a decline in bond prices and rise in interest rates decreases the deflationary threat and this is positive for stocks.
Obviously, deflationary forces change the whole dynamic. Deflation is negative for stocks and commodities, but positive for bonds.
Obviously, deflationary forces change the whole dynamic. Deflation is negative for stocks and commodities, but positive for bonds.
Obviously, deflationary forces change the whole dynamic. Deflation is negative for stocks and commodities, but positive for bonds.
The intermarket relationships during a deflationary environment are largely the same except for one. Stocks and bonds are inversely correlated during a deflationary environment.
The subsequent threat of global deflation pushed money out of stocks and into bonds. Stocks fell sharply, Treasury bonds rose sharply and US interest rates decline.
Asian central bankers raised interest rates to support their currencies, but high interest rates choked their economies and compounded the problems.
Deflationary Relationships
Murphy notes that the world shifted from an inflationary environment to a deflationary environment around 1998. It started with the collapse of the Thai Baht in the summer of 1997 and quickly spread to neighboring countries to become known as Asian currency crisis.
As interest rates fall and the economy strengthens, demand for commodities increases and commodity prices rise. Keep in mind that an "inflationary environment" does not mean runaway inflation. It simply means that the inflationary forces are stronger than the deflationary forces.
In an inflationary environment, stocks react positively to falling interest rates (rising bond prices). Low interest rates stimulate economic activity and boost corporate profits.
This means they both move in the same direction. The world was in an inflationary environment from the 1970's to the late 1990's. These are the key intermarket relationships in a inflationary environment:
A POSITIVE relationship between bonds and stocks
An INVERSE relationship between interest rates and stocks
Bonds usually change direction ahead of stocks
An INVERSE relationship between commodities and bonds
A POSITIVE relationship between commodities and interest rates
A POSITIVE relationship between stocks and commodities
Commodities usually change direction after stocks
An INVERSE relationship between the US Dollar and commodities
Inflationary Relationships
The intermarket relationships depend on the forces of inflation or deflation. In a "normal" inflationary environment, stocks and bonds are positively correlated.
There are clear relationships between stocks and bonds, bonds and commodities, and commodities and the Dollar. Knowing these relationships can help chartists determine the stage of the investing cycle, select the best sectors and avoid the worst performing sectors. Much of the material for this article comes from John Murphy's book and his postings in the Market Message at Stockcharts.com.