Intermarket Analysis Part 3: Bonds, Currencies And Equities

by: Market Scholar

*Please be advised that this article serves as the third of a series of three articles examining current intermarket relationships. I encourage readers to view articles one and two prior to this one. All three articles were completed at the same time and cover different asset classes and relationships

China (NYSEARCA:FXI) has been strong since September and was discussed thoroughly in the previous two articles regarding commodities. While China is important for commodities, it also is important for equities. Note in the ratio chart below, China was underperforming the S&P 500 (NYSEARCA:SPY) up until fall 2013. Since then China has turned to be the outperformer, a sign of strength for both commodities and equity markets globally.

A strengthening Euro (NYSEARCA:FXE) is good for the European economy as well as European equities. This in turn is positive for global equities. It doesn't take an experienced technical analyst to notice the trends in the Euro over the last four years, and it's probably safe to say that the Euro is back in an uptrend. This bodes well for global equity markets.

The Euro, as it is negatively correlated to the USD, is positively correlated to commodities. Accordingly, the recent strength in the Euro is also positive for commodities.

The Canadian Dollar (NYSEARCA:FXC) has consolidated over the last few years, much as the CRB (NYSEARCA:CRBQ) has done. There does however appear to be strength recently, and a breakout in the CRB will likely correlate with a breakout in the Canadian Dollar.

The below charts illustrates some important equity market relationships involving the VIX (NYSEARCA:VXX) and the utility sector (NYSEARCA:XLU). Utilities are defensive stocks, and typically outperform when anxiety, and accordingly volatility, rises. The top (red and black) line is a ratio of the utilities sector to the S&P 500. It's evident that since the financial meltdown, there has been a very strong positive correlation. The same positive correlation also existed prior to the 2007 market top. However note that from mid 2004 to the end of 2007 there was a divergence, with the XLU:SPY trending up, and the VIX trending down. Finally the relationship regained strength, and in 2007 the VIX began to shoot up, marking the top in the market. Accordingly, the XLU:SPY ratio acted as an excellent leading indicator.

Note that since mid 2011 a new divergence has formed; the XLU:SPY has held steady support, while the VIX has trended downwards. If one applies the same analysis from 2004 to 2007, it indicates that a top may be put in equities in the next year or so. Obviously this is far from precise, but as the relationship continues to evolve one will be presented with more accurate readings.

US bond market price action can be very informative of current trends in equity markets. For example, in periods of optimism high yield or junk bonds tend to outperform, while in periods of pessimism treasuries typically outperform. Investment grade corporates are typically found in between.

High yield bonds often trade like stocks, and a ratio of high yield bonds (NYSEARCA:HYG) to investment grade corporates (NYSEARCA:LQD) mimics equity markets even more. The chart below isn't currently ringing any alarm bells, however I really like charts that have high predictive value, and hence thought I would share this one (again credit to John Murphy for writing about many of these relationships). Notice that in the two blue boxes, the ratio chart of high yield bonds to Investment Grade Corporates (red and black line) led the S&P 500 down.

That being said, a similar chart that is however raising alarm is the Investment grade corporate fund to 7-10 year Treasury bond fund (NYSEARCA:IEF) ratio. Again we can see how this ratio closely mimics the price action of the S&P 500. In positive economic times, investment grade bonds, being more risky than Treasuries, will outperform. In deteriorating conditions, it will be the opposite. Notice the divergence since 2013 in the LDQ:IEF ratio to the S&P 500.

If one looks at high yield corporates on their own, it looks that price is confirming highs in equities and showing that risk is on. High yield bonds and the S&P 500 are highly correlated, and HYG often leads the S&P. Note in the chart below that HYG is finally gaining some momentum above the level that held prior to the 2008 crash.

Bond prices and copper (NYSEARCA:JJC) are closely tied to the state of the economy, and it should come as no surprise that there exists strong correlations between the two asset classes. A stronger economy typically implies weaker bonds prices and strengthening copper prices. In article two of this series I noted that there exists multiple signals that there exists an impending breakout to the upside in copper. Note the long-term negative correlation between copper and the 30 year US note (NYSEARCA:TLT) in the chart below. A breakout to the upside in copper could lead to a selloff in bonds. Shorter term technical analysis show bonds to currently be trending down.

While bonds and copper are negatively correlated, the CRB/Bond ratio is positively correlated to stocks. It provides a good indication whether the current market environment is in a "risk on" or "risk off" mode. From 2009 through 2012 there existed a very strong positive correlation. That relationship diverged in 2012, but looks to be regaining strength. Note that the CRB/Bond ratio is grinding its way through downward resistance channels and may be turning up in the near term. This implies higher commodity and stock prices, with lower bonds prices.

The below chart takes the above analysis one step further. It has the same CRB/Bond ratio chart, but this time it is overlaid with the ratio chart of the basic material sector (NYSEARCA:XLB) to the S&P 500. Notice the consistent high correlation which should be obvious as both have commodities in the numerator. That being said, look at the divergence in the last month; the XLB has significantly outperformed while commodities have lagged. This could serve as further justification of potential near term commodity strength.

Due to relationships with inflation/deflation, US bonds yields and the Japanese stock market are highly correlated. Note however in the blue box that while the Nikkei (NYSEARCA:EWJ) has surged since November, the 10-year yield (IEF is the bond price ETF, so the inverse) has failed to experience the same gains.

It is unfortunate that one company can be so significant, but that is currently the case with Apple (NASDAQ:AAPL) due to its heavy weighting in the Nasdaq. As illustrated in the chart below, Apple still remains firmly within two key trend lines. The $500 level is obviously significant, as is the very clear head and shoulders pattern. Friday was a critical options expire date, and it should come as no surprise that Apple closed right at $500.

However as I mentioned last week, most analysts still ignore the long term trend line that has served as support for four years. Given that the critical January 18th options expiry has passed, and the approaching support and resistance lines, I would imagine Apple will become volatile in the near future. A break of either of the two trend lines below will be significant for Apple and equity markets in general.

Finally, so far 2013 has been a period of underperformance for financials (NYSEARCA:XLF); note the small turn-down in the last two weeks at the end of the chart below. Longer term financials are still exhibiting relative strength, however when the below trend lines begin to be tested it will be highly indicative of a market top.

To sum up, currency and commodity markets seem to support renewed strength in equity markets. China and the Euro are both exhibiting strength which bodes well for global equity markets. Apple may prove to be a near term catalyst, and the upcoming Apple earnings announcement this week may have short term equity market implications.

Commodities are typically the final asset class to peak in an equity bull market, and it appears that we are indeed entering the final leg of the 2009 bull market. From 1970 to 1990, every important turn in commodities was either preceded by, or coincided with, a turn in the $USD in the other direction. Accordingly, the dollar must always be kept in focus.

How long the final leg up in equity markets lasts will become more clear as time passes. Continued strength in energy, relative strength in staples, and finally underperformance in financials will be indicative of a market reaching its top. The many ratios used in these three articles should also send signals as to when the trend is changing.

A sharp increase in the price of oil has preceded 7 out of 8 postwar U.S. recessions, and that may be a barometer that is easily followed.

Until any such signals are presented, one likely will be best served being long commodities and commodity related equities.

I'd like to thank John Murphy for publishing his recent book "Trading with Intermarket Analysis" where most of these relationships are discussed. I would also suggest to anyone investing in any markets whatsoever to read it; probably one of the best and most practical investing books I have ever read (twice now!). I have no professional relationship with John, and am simply acknowledging him as I believe his analysis to be most practical.

I'd also like to thank Chris Vermeulen at The Technical Traders for sharing thoughts on current market conditions.

Disclosure: I am long ACI, ANR, CLF, HAL, HOV, LOW, NIHD, RDN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may get long JJC and other commodity related stocks this week. I may short airline stocks. I am currently short LNKD. My time frame is typically shorter term, from a couple hours to a couple weeks