In our comments below we will illustrate how intermarket correlations prove that the U.S. equity markets have been more concerned about deflation than inflation since 1998 and how the same correlations predict the current rally in equities should fail, with new corrective lows should follow.
The link between the Nikkei 225 & S&P 500
It is well known that Japan’s economy has been struggling with deflation since the mid 1990’s. Through most of the 1990’s, Japan’s fight with deflation appeared to be its own problem. However, as the world’s second largest economy at the time, Japan’s economic woes could not exist in isolation indefinitely.
One of the first occurrences of “technical” evidence that Japan was fighting deflationary forces came in 1994 when Japan’s equity prices began to correlate with global bond yields. Typically, bond prices tend to correlate with stock prices. In the latter stage of a normal business cycle bond prices turn down first, leading the equity market. The result is higher yields that eventually compete with stock prices and pull equity indices lower. Conversely, during periods when investors view deflation as a greater economic threat than inflation, the relationship between equity prices and bonds invert so that equities consistently correlate with bond yields.
In the chart below we illustrate Japan’s Nikkei 225 equity index and Japanese Government Long Bond Yields. Prior to 1994 there was no meaningful correlation beyond what we would expect within a normal business cycle. However, between 1993 and 1994 Japan’s inflation rate collapsed from 1.30% to 0.69% with some months producing negative inflation rates (deflation). It was clear to Japan’s investors that deflation was a more meaningful economic risk than inflation. In fact, modest inflation would be considered a positive event because it meant reducing the risk of deflation. In addition, there is an historical positive correlation between inflation and corporate profit margins. As a result, when bond yields increased it reflected the view that the economy was re-inflating, which is positive for equities. From that point forward, the positive correlation between equity prices and government bond yields strengthened.
Nikkei 225 and Japanese Government Long Bond Yields
This positive correlation between bond yields and Japan’s Nikkei 225 equity index continues today. More importantly, as the next chart shows, in 1998 the concern that deflation was a greater risk than inflation spread from Japan to the United States.
The 1998 cyclical bear market in the U.S. followed the Asian Contagion. As the US equity market pulled out of the 1998 cyclical bear market it was accompanied by higher US Treasury Yields and a rising Nikkei 225. From that point to present times, the US equity market has correlated with the Nikkei 225 and U.S. government bond yields. U.S. investor behavior had started to reflect a belief that deflation was a greater economic risk than inflation. This does not mean that the U.S. was experiencing deflation, only that the market behavior and intermarket relationships indicated that deflation was more a threat than inflation. We first wrote about this unusual relationship in 2001, and a full chapter of John Murphy’s 2002 edition of “Intermarket Analysis” was devoted to this behavior. Even though the risk of deflation was apparent to analyst that understood intermarket correlations, it’s only recently evident to most investors and the media.
S&P 500 & 10 Year US Treasury Yield Weekly
Nikkei 225 and S&P 500 Daily
We have read many arguments suggesting an era of hyperinflation is just around the corner, and even more eloquent macroeconomic discussions on why hyper inflation is the least likely outcome for the U.S. Where we cannot add to these arguments based on monetary theory, our charts show us we don’t have to. Considering that the objective of investing is to profit from our transactions, not to prove our opinions right or others wrong; both sides of the inflation vs. deflation debate should agree that the market itself is the final arbiter. In that vein, the market has sided with the deflation argument for more than ten years and is showing no indication of changing sides.
For those who believe that inflation or hyperinflation is just around the corner, we submit that the market will tell us if that’s the case in plenty of time to react. When fear of inflation becomes the dominant market concern the current positive correlation between the equity markets and government bond yields will decouple. Instead of rising together, the equity market will view higher bond yields as a threat. In addition, the downtrend in long bond yields would be expected to reverse. For now, that is not the case.
Lastly, where we agree that bond yields are in the final stage of a secular decline, history shows us that the bottoming process often lasts seven to ten years. Where secular uptrends in interest rates tend to reverse quickly, like an inverted “V”, the bottoming process of secular downtrends tend to be slow and drawn out. As such, a sudden change of the current secular theme would be an historically unusual event.
Is This Equity Rally For Real?
What is important now is that these correlations can be used to help analyze the primary trend of our equity market. Since they first began to correlate, the Nikkei 225 has shown a tendency to lead the S&P 500 at major market tops. As is illustrated in the above chart of the Nikkei 225 and S&P 500, at the bull market peaks in both 2000 and 2007, the Nikkei 225 led the S&P 500. Where the Nikkei’s peaks were more like an inverted “V”, the S&P 500 attempted to double top in both cases. It is our opinion that the sharper declines in the Nikkei 225 were due to the fact that their cyclical bull markets were, for the most part, driven by their government stimulus. In our article "Breadth Indicators & Liquidity Driven Rallies" we provided examples showing that bull when markets driven by government stimulus end, they tend to not provide investors with the typical warnings that so often lead major market tops.
As of today, there are several ways we have used the above information to support our conclusion that the April high marked the end of the rally from the March, ’09 low.
- The change in trend of the US equity market is supported by a similar change of trend in the Nikkei 225
- The April high in equity prices was led by a decline in US Treasury Yields that continues today.
- The Nikkei 225 is displaying similar relative weakness to the S&P 500 that it did during, and just prior to, the 2000 and 2007 bull market tops.
The final point noted above, regarding the relative weakness of the Nikkei 225 to the S&P 500, should also be stressed because ever since the two indices became correlated, every major rally or new cyclical bull market has been accompanied by a brief period of outperformance from the Nikkei 225. Thus, as long as the Nikkei remains weaker than the S&P 500, we can conclude that a sustainable intermediate trend rally is not likely.
Lastly, in addition to the technical argument for the importance of the relationship between Japan’s equity market and the U.S., there are fundamental reasons to pay attention to Japan as well. Even though Japan is no longer the world’s second largest economy, it is still large enough to be of significance. The United States and China make up 29.30% of Japan’s imports and 33.80% of Japan’s exports. As such, a slowing of either or both the US and China economies will have meaningful negative repercussions on Japan.
Simply put, even if the U.S. equity market continues higher in the near term, as long as the relative performance of the Nikkei 225 remains weaker than the S&P 500 it is likely that the U.S. markets are in a topping process with very limited upside potential or, more likely, the early stage of a new bear market trend.
Disclosure: No Positions