As I write this, the Dow (DIA) is crushing 14600 with one fist and threatening 14700 with the other. A number of commentators have noted recently that there is something rather strange about this charge upwards: its unusual composition, its typically American nonchalance with respect to woes abroad, and its failure to bring commodities along for the ride. The stock market just doesn't seem to "get it."
Depending on what technical techniques you might use, there may be good reason to expect a pullback of some kind in the near future, but in this article, I would like to argue that, based on an analysis of the historical relationships of bonds, equities, and commodities for the last few centuries, this is not an especially atypical bull, and it is more likely that stocks will be higher this time next year than lower. Any dips that come are likely to be buying opportunities.
The reason is falling commodity prices (GSC). And, I believe that has something to do with the divergence we have seen in BRICs and other emerging markets.
As The Inflation Trader recently pointed out, the high correlation between commodities and equities is one of rather recent provenance. One might wonder if it was the intermarket expression of the "New Normal." Historically, however, real commodity prices have been inversely correlated with P/E ratios, and since equities have tended to be bullish during rising P/Es for the last century, we can say that commodities and stocks tend to inversely correlate with one another.
If, as I have argued in recent articles, energy (especially oil and gasoline) is a leading indicator of moves in P/E ratios, the decline in crude prices from the 2008 highs (more pronounced in real terms) have been promising bullish stock markets, and this one, despite the weeping and gnashing of teeth, has remained quite buoyant.
The confirmation of this bullish posture in equity markets was the blow-off tops in precious metals in 2011.
My favorite way of synthesizing this relationship between precious metals and energy is through the oil/gold ratio. In simple terms, when the oil/gold ratio is low, equities rise and commodities fall; when the ratio is high, commodities (especially precious metals) rise and equities turn flat. If we take into account the sudden divergences and spikes, sharp moves to extreme levels in the oil/gold ratio can be used to time transitions from commodities (especially gold) to stocks and back. The 0.05 level has typically been a rather extreme low level; 0.12 high.
(Source: St Louis Fed)
By all of these measures--the decline in the real price of oil, the spikes in precious metals, the extremely low oil/gold ratio--stocks should be bullish unless a new fundamental principle in intermarket relationships that I am unaware of has interposed itself. And, of course, that is always possible. One thing that has impressed itself upon me in my research of intermarket forces spanning the last three centuries is that, under the monetary system that has been evolving over the last century, sudden reversals to what were once considered stable relationships can occur and become the new norm. Some examples include the relationships between money supply and velocity, unemployment and inflation, or one I am using here, the relationship between gold and P/E ratios.
So, is it wise to put so much weight on a commodity like gold that has only been freely priced for forty years? Perhaps not, which is why I think it is important to use other industrial and agricultural commodities, as well as other precious metals to confirm these movements. The decline in silver, in nominal and real terms, as well as relative to other commodities, is an especially encouraging indicator that P/Es will continue to rise and bring stocks with them (and bring commodities down).
Michael Gayed's recent article seemed to suggest that weakness in the copper/gold ratio does not confirm this story, but the metals/gold ratio is a somewhat less reliable indicator. The copper/gold ratio, for example, has steadily risen for the last thirty years, largely irrespective of whether the market was in a secular bull or bear. Gayed, I should note, seems to be looking at this from a more short-term, cyclical perspective, so he may be proven right with respect to near-term moves, but broadly speaking, weak commodity prices are promising continued good news: rising equities, falling unemployment, and low inflation. And, in this instance, the sharp drop in the copper/gold ratio in 2011 is actually a bullish sign, insofar as it is the result of the precious metal 'shock' indicative of the end of the commodity trade and the beginning of the equity one.
I believe that this weakness in commodities is part of the reason we may be witnessing a divergence in emerging markets such as the BRICs. These are all markets that outperformed during the commodity run of the 2000s. Indeed, since the precious metal spikes of 2011, they seem to have increasingly underperformed the US.
It would not be surprising to see commodity producers such as Brazil (EWZ), Russia (RBL), and South Africa (EZA) suffer under this Really Old Normal (i.e., such as in the 1990s), but it will also be interesting to see how a commodity consumer like China (GXC) responds to this new environment. The 1980s and 1990s were marked both by weak commodities and bullish stocks, but also by a series of Asian bubbles: Japan in the 1980s, Asian Tigers in the mid-1990s. Both seem to have been pricked by temporary spikes in commodity prices, and one wonders if China might be next.
Spikes in commodity prices are always problematic for markets. Oil shocks are an especially reliable indicator of equity trouble, and what I call "Leeb oil shocks," an 80% rise in year-on-year oil prices, are especially predictive during secular bull markets. (Oddly, these Leeb shocks are also useful predictors of gold prices during commodity bull markets).
Strictly speaking, following the rules as laid out by Leeb, there is no need to predict oil spikes. One need only wait for that spike to manifest itself, and then pull out. But, in my search for predictors of oil spikes, I found that all of them (including those attributed to geopolitical disturbances) have been preceded either by a spike in the gold/oil ratio or by a relatively flat Treasury curve, often both, by four or five quarters. Last summer, at the bond top, the curve got squeezed down to about 1.4. That is a little too narrow for comfort, but it would be a rather wide spread to signal an oil spike. Usually the spread is below 1.0; once it was 1.2.
That would place the highest potential for an oil (OIL) spike sometime this fall (if one had to occur), after which clear sailing would seem to be in store for at least as far as the spring of 2014.
Using historical behavior as a guide, virtually all of the signals from commodity markets are that stock indexes should "expect to be surprised" to the upside. The only other negative possibility that I can imagine is another banking or currency crisis, such as we had in 1982, 1998, and 2011, which resulted in something like 20-25% declines in equities from previous highs. Both 1982 and 2011 appear to have been linked to the transition from a shift in momentum in market forces, specifically an end to lax conditions in peripheral markets.
It is obviously impossible to be absolutely certain what will happen over the course of the next twelve minutes, never mind the next twelve months, but I think that there is more risk at the moment to those waiting for another European shoe to drop. By the time the news convinces you that it's finally okay to jump back in, it will probably be too late.
Additional disclosure: I am long June Dow futures and short AUDJPY.