Intermarket Analysis

By: Jordan Roy-Byrne | Thu, May 10, 2007
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(Sent to Trendsman readers on May 1)

One book that is required reading for the Level 3 Chartered Market Technician Exam is "Intermarket analysis" by John Murphy who is essentially the father of Intermarket Analysis. This type of analysis focuses on commodities, stocks, bonds and currencies and the relationships each and all have on each other. For example, to better decipher the trend of stocks, one would also analyze bonds, commodities and currencies. Intermarket analysis has become more popular given the increasingly correlated financial world. A major point in the book is how foreign markets now trend together. For example if US bonds are falling we can expect foreign bonds to fall too.

Would you believe that the deflation fears we in the US experienced in the early part of this decade, originated with Japan in 1990 and then took root with the Asian Financial Crisis in 1997? When the Thai Baht collapsed in 1997, it triggered a currency crisis across East Asia that forced multiple nations to raise interest rates significantly in a move that would trigger deflation fears from Asia to America.

Of course today we are in an inflationary world as money growth in the leading nations is at or well above double-digit rates. This reflation effort started with Japan's zero interest rate policy and was solidified with the Federal Reserve's actions in the wake of 9/11 and the 2001 US recession. Since then, everyone else has joined in the reflation effort.

What can intermarket analysis tell us about the current and future state of global markets?

First, let's go over some of the relationships. Commodities lead bonds, bonds lead stocks and stocks lead commodities. The relationship between stocks and commodities can be very tricky though which I will get into later. Lastly, bonds and stocks trend together except in a state of deflation in which bonds will rise and stocks fall. As an example; gold peaked in January of 1980, while bonds turned up in late 1981 and then stocks followed in 1982.

In the current cycle, commodities made a double bottom in 1999 and 2001. The dollar peaked at the start of 2002, while bonds peaked in 2003. Since then commodities have exploded, the dollar has fallen by roughly 33% while bonds have treaded water below the 2003 top. Some analysts have pointed to the action in bonds as a signal that inflation fears are overblown. While bonds have yet to solidly confirm inflation fears, everything else has. Why have bonds yet to confirm inflation fears?

Simply put, the US bond market has benefited from a strong global economy. We have large trade deficits with Japan and China and both nations have recycled dollars back into US Treasuries to support the dollar and low rates which protects the US consumer who buys Asian goods. Secondly, high oil prices are a boon for both energy rich nations and OPEC and, the US has benefited as the prior parties have used part of their earnings to buy US Treasuries.

Now you may be thinking, why would foreigners want to buy US Treasuries? I ask the same question. Here's the answer. Foreigners still hold the US in a very high economic regard. They are likely to perceive US debt as safer than debt from their own country. So the aforementioned explains how bonds have held up. But let's look at a chart:

US Bonds

In this very long-term chart, bonds are close to breaking down out of this head and shoulders pattern. I should add that the H & SH pattern is one of the most bearish and reliable patterns in the book. While bonds have held up okay in the face of soaring commodity prices and a falling dollar, their negative fate is approaching. Before I get to stocks I want to show a few dollar charts and make a few points.

The bearish chart on bonds coincides with the following bearish dollar charts.

Dollar Monthly

Dollar Weekly

I am now expecting the greenback to break below 80 within the next three months, unless it can rally above the resistance I identified. Remember in my last email I mentioned that I felt the dollar was actually overbought? Jim Puplava this weekend said that foreign central bank treasury purchases were up 37% (year over year). It is truly amazing how weak the dollar is, given that kind of support.

The Australian dollar has broken out to a 17 year high. Currently at 83, it has two precise technical targets. The first is 92 and the second is 114. The New Zealand dollar index has broken out and against the greenback. The Kiwi index is at a 25 year high. The British pound has broken out to a 15-year high and a 26-year high against the greenback. The Canadian dollar at 90 has a long-term target of 117. The "technical" reason why the dollar has failed to breakdown is because the Yen has been very weak over the past two years. Any strength in the Yen would put even greater downside pressure on the dollar index. To conclude on the currency front, the long-term breakouts in numerous currencies is confirmation that the dollar is set to breakdown. Had these foreign currencies not broken out, then the picture on the dollar would be less bearish. Not the case though.

The fact that the dollar is close to an all time low and that gold is close to an all time high reinforces the high probability of a coming breakdown in bonds. We could also assert that, while bonds usually lag commodities and currencies, a plunge will help push the greenback and gold to levels never seen before.

Now let's get back to stocks.

The US Market continues to defy even conventional logic. Fortunately, intermarket analysis can lend us acute insight in this matter. I noted above how bonds lead stocks. Bonds bottomed in 1981 and then stocks in 1982. Next time around bonds peaked in 1998, two years before stocks in 2000. (Though bonds later decoupled from stocks). According to Murphy's book, bonds on average peak 18 months before stocks and 27 months before the economy. While bonds did peak in 2003 they have yet to fully breakdown. The breakdown looks like it is coming in the later half of this year or the early part of 2008. Thus, we could expect a breakdown in stocks to follow. I would say roughly after the summer Olympics in 2008 to early 2009. Though we have to keep in mind the possibility of inflation boosting the market in nominal terms as it is doing at the moment.

So the fact that bonds have not broken down yet is helping to extend the gains in the US market. Referencing the above, it is global strength that has supported US bonds and thus the US stock market. On FinancialSense this weekend Frank Barbera made the point that the US market is no longer responding to US economic fundamentals but to global strength. Murphy stressed a similar tune in the book. Global markets trend together. Since 1997 it is quite clear that Asia, and not the US is driving the global economy. Thus, the US market, albeit weak, is following the global trend.

Now lets get back to the relationship between commodities and stocks. Stocks tend to lead commodities. Commodities are an inflation hedge and, price inflation and higher inflation expectations occur at the end of the business cycle. It takes time for money and credit growth to make its way through the system, from causing rising prices to rising inflation expectations. Thus, commodities usually outperform at the end of the business cycle.

While commodities have and will continue to outperform stocks in the bigger picture, we are looking at the business cycle here. In the past 12 months, both global and domestic stock markets have outperformed commodities as a whole. It is when commodities outperform stocks, that you are nearing the end of the cycle and recession.

With both bonds and the dollar ready to breakdown, commodities should reassert leadership in the coming months. Given the current state of the various markets, and given what we have learned from intermarket analysis, here is what we should expect in this order over the next few years:

Dollar breakdown
Bond breakdown
Commodities outperform
US stocks peak
US recession
Foreign bonds peak
Foreign markets peak
Commodities peak
Global bear market
Gold peaks

Yes, US stocks should have peaked sooner as they usually do 18 months after bonds and 9 months before a recession. The aforementioned global factors, not US fundamentals, are driving the market higher. Foreign bonds still look good here so global strength should continue for at least 18 months. However, the first two things on the list will eventually ripple into the global economy. Foreign economies are becoming more immune to the US, however "markets" are always correlated. While the US sinks into a severe recession and possible depression, global economies will be able to recover because of the productive investments that have been made.

As I have previously mentioned, the US cannot afford to raise interest rates because of extremely high debt, the budget deficit and a lack of savings. Foreign central banks will eventually raise rates (already have) and curtail money growth, which will cause recession. However, foreign economies have built up productive capacity, which has generated surpluses and savings. These things will allow those economies to recover while the US will languish.

In summation, intermarket analysis confirms my view that commodities will experience another 18-24 months of gains. Commodities outperform at the end of the economic cycle. Thus, investors should not be worried about the fact that the US and global market indices have outperformed since May of last year. That happens mid-cycle.

In terms of the precious metals, this analysis could mean that it may take longer for precious metals to breakout and outperform. I will continue to watch the Hui/Spx ratio. Remember that gold does best when the stock market is in its initial bear phase. With the state of the dollar and bonds, gold should still breakout in the next few months. The out- performance/ leadership though will come after the breakout and not with the breakout. So gold bulls should take solace, as the intermarket cycle has not yet dictated a gold surge but will soon.

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Jordan Roy-Byrne

Author: Jordan Roy-Byrne

Jordan Roy-Byrne, CMT
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