Tuesday, February 17, 2009

Intermarket Analysis

This is the first article of a series that will be presented on intermarket relationship.

In the last 4 months the US stock market has held its range of Dow Jones 7800 – 9200. Present report shows that we may be very near to a break away from this range. The intermarket analysis generally relies on the following markets correlations.

To summarize the correlations -

Stocks and bond prices are positively correlated, bond prices (note: bond prices and not bond yields are mentioned here) lead stocks in both bear and bull markets.
Bond prices and commodity prices are negatively correlated; commodities lead bond prices by a small margin.
USD is inversely correlated to commodities; its leading characteristics have not been very strong.
A rising USD is good for US stocks, but not essentially for other markets like emerging markets in general (domestic currency strength is actually good for other markets barring few exceptions like China).

US Bonds have rallied strongly along with a fall in stock averages. This is not congruent with the intermarket analysis which says bonds should follow stocks. However the missing piece of puzzle is the previously held disinflation expectation and the deflation expectation. The four important markets have given a clear signal that strong deflationary expectation was built into the system. This is clear in hindsight as US bonds rallied along with the USD as a safe haven of last resort and commodity prices declined at a record pace.

In the current market scenario the US Bonds have started their descent which looks quite strong. My basic assumption now is that the US Bonds formed a top in December 2008 and has started a bear trend. This would be confirmed once the US Bonds Futures (USH9 Bloomberg ticker) trades below the 200 DMA on a sustained basis.

Taking the assumption forward that the US bonds have peaked we can come to the conclusion that the deflation expectation in the markets have reduced and the current USD strength is not based on a safe haven bid. Now put historical market developments into the picture.

L.A. Times article dated March 30, 2000, “The red-hot U.S. economy, powered by heavy spending by consumers and the federal government, was roaring ahead at an annual rate of 7.3% in the final three months of 1999, the fastest growth rate in nearly 16 years.” The US economy grew at the fastest pace and the US 30 yr Bond prices were rising at the time. Crude oil traded at a ‘very high’ price of $37 which lead the US President Clinton to tap the SPR. Every trader and investor was bullish at that time as NASDAQ led rally made higher highs even as DJIA had stopped making new highs.

Compare this to the present scenario. US 30 yr Bonds are falling, crude oil prices are near lows, US stocks are making new weekly lows and USD holding its strength. This suggests that the US Bond market is discounting growth. The positive slope of the US yield curve signifies inflation expectation getting back into the system. Commodity prices are generally the last to reverse after a major market trend. However the current bear trend in commodity prices in USD terms is strong and will take years to end. A stronger USD will lead to weaker commodities and stronger US exports.

Does this mean that the current financial crisis has run its course?

It would be very difficult to pin point a time for reversal but intermarket analysis shows that US stock market is in for a period of unsustainably lower prices. In the past, the US stock market has lagged deflation oriented bond market signals by more than 6 months. If the bond markets peaked in December then we are in for a lot of cyclical strength in the US stock markets. This could well mean that bonds may keep falling with stocks remaining in a range or stocks may rise relative to bond prices.

Stock market movements are not guided of this market correlation on a day to day basis. But over a period of time these correlation kick in and give strong cyclical reversal signals.

Currently the strength in the USD has been viewed as a ‘risk aversion’ rally. This has lead to liquidation in all the asset classes. In following graphs will show that USD is on the brink of a major bull market rally. It has gapped up today and can lead to strong rally if it manages to close above 87.65 today.

US 30 Yr bonds are declining and there is little to say unless they start trading above 131.

Commodity indices have made a H&S pattern and a next downtick can lead to lower levels.

US stocks have formed a major continuation pattern, a triangle which will resolve bearishly on an S&P 500 close below 805. Present index level in 825.

In the short term a rally in USD can lead to a strong down-leg for commodity and equity markets. This would be probably the last leg down for most of the Asian markets but just a bear market intermediate low for Western markets. With USD gapping up today there is an expectation that the trend in most markets will resolve in a day or two. In the medium term intermarket analysis is signaling a cyclical bottom in equity markets. But equity markets have a tendency to lag. If USD breakouts of this range, we would see a sell-off which will mark the low. S&P 500 will see support at 640 after 805 and 780 are taken out. This breakdown in US stocks would be against the intermarket analysis but short term lags cannot be predicted as market sentiment leads the market behaviour.

USD Index

US 30 Yr Govt Bond

GS Commodity Index

US stocks - S&P500