Intermarket Analysis

The last one week has been eventful for the western equity markets. In the last article it was mentioned that there are four major trends emerging.



Long term US bonds have formed a top in the last quarter of the calendar year 2008. Commodity market are now in a major bear market which will last for many years including sharp bear markets upside rallies. USD will continue to strengthen, not on risk aversion though. Equity markets may bottom out by H209.



The equity markets declined sharply in the western world and have made new lows. Emerging markets have remained quite resilient and are far from their lows made in November 2008. Accelerating deterioration in the world banking industry may lead all markets lower in the very short term. Intermarket analysis shows that the current downtrend in equity markets is decelerating but is not reflected in the equity market averages. Momentum studies are oversold but the trend remains to the downside. Equity markets remain a sell as the trend remains down, unless proven otherwise. But caution should be exercised as diverging signals are emerging from bond markets and currency markets.



Gold prices have performed quite strongly in comparison to all other asset classes. Gold has continued to move up even with USD holding onto its strength.



Risk aversion sentiment has worked well in favour of gold prices. The USD has seen lot of inflows as it is the least unattractive of the collection of ugly sisters that populate the world’s major currency markets. Gold has a tendency to give trend reversal in the first quarter of a calendar year. This is quite evident from major market bottoms and top that has been formed over the years. The only thing that can work in favour of gold prices now is the continued selling in world equity markets and deteriorating condition of the world currency markets. Taking a cue from the strength in gold prices it can be inferred that market sentiment in equity markets has touched lows which have not been seen in the last ten years.



Dow Jones:Gold (Dow Gold Ratio)



Equity markets rally in 1999 made Dow Jones most expensive as priced in gold terms. Currently this ratio is off 3 points from its long term average of 10. This means equity prices are getting cheaper in real money terms. This also means as and when stock prices make a cyclical bottom a lot of money will flow out of gold and into equity markets. The first quarter is just the time that it can happen as bullish sentiment in gold scales new peaks and bearish sentiment in stocks makes new troughs.



Now for this to happen, an early indication can be seen from a rebound in banking stocks. If the markets are to rebound, the financials should bottom out first. This would lead to a return to relatively risky securities and lead the gold prices down. This would also mean the USD will strengthen further as faith in the currency markets return to normal.



Continuing with the assumption that US 30 yr govt bonds have started pricing in some growth expectation, US equity markets can well give a sharp upmove after the current selling is over. However there is little evidence of any price reversal in major market averages in the US other than some oversold readings. Some important indicators to be analyzed are the relative performance of market majors.





Johnson and Johnson (JNJ) to S&P 500 ratio




Clearly JNJ to SPX ratio made a high of 0.070 in the bear market of 2000s. The high of this ratio coincided with the bear market low with a lag of 2 months. The stock market did decline by 40% in that bear market and moved up to make new highs. Although the current bear market is much larger in economic deterioration, still the averages would always kick in on a relative basis. There are other sectoral ratios which have gone beyond all previous bear market lows. One such ratio is the relative performance of tech stocks like Qualcomm. In the bull market the major tech stocks like Qualcomm were the first one to make a lower high before the big break came.



2009 bear market non-confirmation



2000 Bull market non-confirmation




http://www.federalreserve.gov/releases/cp/

The current stats from the Federal Reserve show very little activity in the CP market for Financials. Only Non financial with investment rating of the highest quality has seen some takers. This is in contrast to the rebound seen for financial CP markets ahead to the Dow Jones rally to 9000. The credit market for financial and sub investment securities is still inactive and this is clearly weighing on the market sentiment.

Commodity markets have remained relatively flat in the last one week. Industrial metals have seen a lot of selling along with a fall in the agricultural commodities. Grain markets have seen lot of price erosion and are still looking weak. Commodity index looks set to fall further and make new lows.



30 Year US bonds are consolidating and can continue its downtrend on a break below 125. The activity in the bond market is suggesting that a reversal in stock market is imminent. Equity markets have a tendency to lag by two quarters on an average. This gives us and idea that equity prices in US may find a cyclical bottom in the next few months.




Triangle breakdown in S&P 500 has seen rapid price erosion. Though momentum indicators are quite oversold, there is no indication of a reversal and the trend remains ‘down’ unless proven otherwise.



S&P 500 is now trading well below 2002 lows. A giant double top is also forming which shows weakness for equity prices in the long term is it trades below this level for another quarter.



USD index looks strong. Though there has been some short term correction, the trend still remains up. The pivot trend reversal remains 84 for the USD index.



In the current scenario, continue to look for weakness in equity markets across the world. Short term caution is warranted as divergences in market averages are reaching extreme levels. It is important to note that we have conclusively entered the last leg down of the current bear market in emerging market equities and the last leg down for cyclical bottom for western market equities.

Commodity prices will continue to weaken with agricultural prices leading the way down along with industrial metals.

USD looks strong. USD/JPY will give a strong upmove on a daily close above 95. Look for 102 to be tested as market has formed a cyclical bottom.

US 30 Year bond looks set to fall further on a daily close below 125.

Elliott Wave Count on Gold

I will update my count on gold in few days. I have been proven wrong on the ending diagonal part. There is new data that has to be analysed and put into perspective.

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