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Intermarket Analysis and Drivers

Written by: Ryan Puplava

Typically, I write Market Observations for Financial Sense that are either very narrow or very broad in focus. On this occasion, it will be a broad market observation as I check in with the asset classes, major indices, and sectors to identify trends, strengths, and weaknesses within Mr. Market. There will be a lot of charts because I think like John Murphy, the chief technical analyst at, the technical work is the leading indicator of the fundamental work. I believe it’s better to agree with the market than to be asking the market to agree with you, but that’s just my personal bias as a market technician.

Let’s start at the top and then work our way down. The first choice one has in forming a portfolio is about asset class, of which there are three: equities, bonds, and commodities. I guess you could say there might be a fourth: cash (or other such short-term maturity/liquid funds). One’s exposure to each is highly dependent upon your growth or income versus risk objective for investing; however, if none of that mattered we should take a look at each class on its own merit. The first of which is equities.


There are many possibilities within equities: domestic versus foreign, large versus small, and mature versus growth; but if the broad market isn’t healthy, it is likely most of the subgroups above will have a tough time.
“As they say on my own Cape Cod, a rising tide lifts all boats. And a partnership, by definition, serves both partners, without domination or unfair advantage. Together we have been partners in adversity—let us also be partners in prosperity” John F. Kennedy.
So equities are all partnered in the same pool of global liquidity as multinational companies (business) and the internet (communication) have broken down barriers, such that one likely cannot rise or fall without affecting the other, and vice versa. We saw this clearly in 2008 when many thought that foreign markets would be able to avoid a decline in the U.S. economy—such was not the case.
I look to the indices when gauging overall price health. Many quote the big 30 in the Dow Industrials or the S&P 500. Many forget about the Wilshire 5000. Now that’s an ocean of an index with plenty of boats. If the water isn’t rising for the Wilshire 5000, then it probably isn’t for most of the corporate boats in the U.S market. It’s pretty clear to me that the Wilshire 5000 has experienced a “v-spike” recovery from the Libya/Japan events. The “V” in v-spike discusses the shape of the chart, but I think it can also refer to vertical because that’s exactly the direction the market has taken since March 16th.
wilshire 5000 composite index

We have stalled near the February highs without a breakout recently. Complimenting the stall here, the RSI has not broken to higher, “bullish” hemisphere territory above 70. You can think of it as operating like a satellite. We are in lower orbit and need some momentum to push this market to the bullish outer orbit. 60 is a reading that typically rebuffs bear market rallies and ongoing bull market corrections/consolidations. It is my belief that we will further consolidate sideways unless we get some new blood as shown by a breakout of more than 1-3% in the Wilshire 5000. Such a breakout would likely be confirmed by 1) volume and 2) a day in which 90% of the NYSE advances higher, a.k.a. breadth.
wilshire 5000 weak lower orbit resisitance near 60


Looking at corporate bonds, the trend has been higher prices since the Credit Crisis of 2008—a time when creditors questioned the viability of their debtors as a going concern. As the economy continues to recover as referenced by economic activity in the ISM manufacturing and non-manufacturing index levels above 50, then credit risk is lowered and bond prices rise.
Investment Grade Corporate Bond (using the iShares ETF, LQD, as a proxy) prices took a break towards the end of 2010 at the first sign of rising interest rates as shown in the 10-year Treasury yield. High yield corporate bonds (using the HYG ETF as a proxy) also corrected at the end of 2010, and again recently during the Libya/Japan events in February and March. However, it appears that high yield corporate bonds are back at the 2010 and 2011 highs, which appears bullish to me considering that the new long-term trend for Treasury rates have been, as a whole, on the rise for the 10-year Treasury Note since October 2010.

I think it’s highly significant that corporate bonds are doing well despite the rise in Treasury yields because bond investors are telling us that they prefer corporate debt over government debt. Consider the balance sheet of the government, near $14.3 trillion, versus the balance sheet of the American corporation and there’s no wonder that such a trend has been prevailing. Bond investors must realize that we are not in a hyper inflationary environment (despite the rise in commodity prices and the easy money from the Fed) and we are still in the midst of an economic recovery with low wage inflation. Inflation of the money supply and a subsequent rise in commodity prices have only just started to tap into rising prices for finished goods (Wal-Mart and Hershey’s price increases recently come to mind).
That means corporate bonds are still a viable investment strategy in the current environment; however, it appears that the easy money in 2009 and 2010 is over for that trade. As interest rates rise and the business cycle becomes extended, corporate bonds will not be the place investors will want to be if they’re concerned about preservation of their principle; or at least, high yield might not be the best place and a shift to investment grade quality would be the way to go for relative returns.

Commodities have been in a secular bull market for ten or so years. At PFS Group we don’t pigeonhole our investment strategy to one asset class. As Jim Puplava has said many times over on his radio show, there is a time and place for every investment strategy. In the 70s it was commodities, in the 80s it was bonds, in the 90s it was technology stocks, and in the 2000s it has been commodities again—full circle.
In John Murphy’s book, Intermarket Analysis, he discusses the many relationships between the different asset classes. I highly recommend the book, even if you’re a micro fundamental analyst or bottom-up investor. John Murphy’s background was based on his economics education in college so his grasp of the markets from a technical prospect is not without its economic underpinnings. Back to the book—Intermarket Analysis acknowledges the relationships between asset classes and highlights that when the U.S. dollar falls, commodity prices rise. Well, the U.S. dollar has been in decline for sometime…
usd dollar

…Which has led commodities into a super bull market with one major pit stop (2008).
us commodity groups

Year to date, energy has been the top performing commodity group with livestock in a close second. The reasons for energy’s performance are obvious with Middle Eastern political unrest and widening refining margins, but I’m surprised more aren’t talking about the gains in livestock this year (mainly cattle). The Goldman Sachs Livestock index is up nearly 15% this year. Droughts across China and fires in Russia increased grain prices during 2010. As input prices rise, ranchers need to charge more for their livestock. As the global economy continues to recover from 2008, diets will want to include more protein. In addition, China’s beef imports are expected to rise in 2011 just as their rate of production has declined. It’s expected that beef import volumes will go up 38% from 2010. This is occurring just as negotiations continue with Canada and the U.S. to resume beef trade that was banned since 2003. In addition, the melamine scandal of 2008 eliminated nearly a million dairy cows. China’s herd will need to be rebuilt!
I wrote a bullish article on gold prices just a couple of weeks ago, here, that highlighted the bullish setup in gold chart patterns in addition to seasonal strength. Also in that article were mining stocks that had already broken ground through individual price resistance levels. Many precious metals miners continued to join those mining companies (that broke out of bullish technical patterns) on Tuesday when the Market Vectors Gold Miners ETF (NYSEARCA:GDX) rose 4.95 percent. It wouldn’t surprise me to see those companies retest their respective breakouts here, as the U.S. dollar continues to flirt with the October 2010 low, but overall, the picture looks very bullish for precious metals short and intermediate term. However, as I warned in that article, investors would be smart to look ahead and not get too emotional about rising precious metal prices; headwinds could eventually affect the intermediate term in a summer selloff if investors begin to worry about the end of QE 2, precious metal seasonality kicks in, and the leading economic indicators (LEIs) rollover—suggesting a mid-cycle slowdown.
Concerning energy, I’ll make a long story short: political unrest in the Middle East is a structural problem and it’s here to stay for some time. The price of oil, natural gas, coal, and other alternatives are highly affected by world events right now. There’s political unrest in the Middle East. Nuclear powered environmental hazards in Japan. Solar Power stimulus budget cuts in Germany, Italy, and here in the States. Refining margins are blowing up just as capacity has been cut off in Japan. Storms have flooded coal mines in Australia. There’s a lot going on in energy!
Political unrest in the Middle East is occurring because as those societies haven’t spent a lot of their energy earnings back into developing their economies, the youth are left without any real job growth. As the internet makes our large world smaller and reachable, it’s breaking down borders and ethnocentric walls. The youth see freedoms in other countries and they want that for themselves. Higher food and commodity prices are destroying living standards for the lower class in those countries; thus fanning the flame of unrest.
What’s scary now—with the Middle East is earning its freedom—is exactly how much control will extremist groups now be able to exercise in molding political debate and policy. Stable (as far as the flow of black gold is concerned for the U.S.) dictatorships were tolerated by the U.S. for decades. Why the hesitancy in helping Libya? Politicians in Washington are obviously stuck between a rock and a hard place. We need stable prices and flows of oil (which we had in the old regimes) but we are also the supposed champion of freedom and human rights across the globe. Again, the picture isn’t quite clear how pro-western the new political regimes will be; and therefore, the question arises, will there be stability in the region after we have stepped in to assist in regime change?
The Arabs already question our motives helping in Libya but not in Bahrain—the one U.S. Navy base we have available to our forces in the Gulf. You might not recall, but we had to pull teeth to use Saudi soil in the last Iraq war. Are there any Russian or Chinese bases on U.S. soil? No, likewise, the Arabs do not like to see our military presence on there’s. We didn’t help in Bahrain because there’s no telling if the new regime would have told us to leave or welcomed us with arms wide open. Especially since the Shiites that have been leading these uprisings are not clearly pro-western. As Obama said, our “interests”.

Cash and cash-like securities (T-Bills)

I know what you’re going to say, “Cash is Trash”. You’re not alone in your thinking. As Chris Puplava has demonstrated last week, the currency pairs clearly show that the U.S. dollar has performed very near the bottom of the list. In the last 6 months, the U.S. dollar has only risen against the Iceland Krona, Turkish Lira, Peruvian Sol, Hong Kong Dollar, Thai Baht, and the Argentino Peso. In the last year, two are eliminated from that list.
usd currency pairs

By the way, ever look at the weighting of the U.S. dollar index? See China, Russia, India, or Brazil in there? Nope. There’s growing concern by the largest players in the global trading market (mentioned above) about the relevancy of the U.S. dollar as the world reserve currency.
Not only is cash trash, but Bill Gross and Warren Buffett have made it abundantly clear that T-Bills and T-Notes are also trash. They’re right. It doesn’t take a billionaire to see that the U.S. government is going to have its comeuppance. Congress is locked in debate over the budget. The newly elected Republicans that pledged responsible government spending are being challenged by the status quo, and that status quo has surmounted almost $14.3 trillion in debt, our legal debt ceiling.
“If the debt ceiling is not increased by May 16, Geithner said the Treasury has authority to take certain extraordinary measures to temporarily postpone the date the United States would default on its obligations…However, those actions would be exhausted after about eight weeks and there would be "no headroom" to borrow within the limit after July 8, he said.” U.S. Will Hit Debt Limit No Later Than May 16, Geithner Says
Will the U.S. need a bailout from our global partners? The 10-year Treasury yield has broken its intermediate trend down recently, probably in light of our current 2011 budget problems. The long-term trend is back on course with rising rates that began last October.
tnx 10 year treasury note yield


Currently, year-to-date, there are only two S&P sectors that are outperforming the rest of the market. That’s energy, at the top, and industrials. Notable mention is deserved for the materials sector as the most improved sector since the March bottom.
s & p sector etfs

If we look at the sector rotation model as based on Sam Stovall’s S&P’s Guide to Sector Rotation, when industrials, basic industry, and energy outperform, that says you’re in a bull market portion and the economy is in early recovery. The S&P 500 is up 90% from the 2009 bottom. Economic indicators also compliment the theory that the economy is in early recovery. Our economic models at PFS Group concur with this setup. On the horizon, as the LEIs rollover, we should see a transition later this year towards the consumer staples and services sectors as based on Sam’s sector rotation guide below.
sector update

Despite the Industry and Energy sector’s lead performance, there are select sub-industry groups that continue to perform and show bullish new highs. A few breakouts should by highlighted.
The S&P Biotech SPDR (NYSEARCA:XBI) broke out of a three-month long consolidation recently. While price is near channel resistance and momentum indicators are overbought, the primary trend higher seems to be holding very nicely. Valeant’s unsolicited proposal to Cephalon appears to be moving momentum into the group.
spdr s&p biotech index etf nyse

The S&P SPDR Pharmaceuticals Index (NYSEARCA:XPH) broke to new highs recently suggesting renewed momentum for the industry group.
spdr s&p pharmaceuticals index nyse

The last industry group I want to point out is the S&P SPDR Retail Index (NYSEARCA:XRT) which has also broken to new highs recently. Now, how is it possible for retail stocks to be doing so well with high oil prices? Aren’t we suppose to see discretionary spending cut back? I’m sure that oil is doing that for budgets that are already pressed, but remember we have quite the two-tiered economy in which those who own assets versus those that do not creates such a dichotomy. Isn’t that usually the case in an inflationary environment? The majority of diversified investors with 401k plans and other stock accounts have done well these past two years as the market has recovered from the 2008 credit crisis. Recently, Bed Bath and Beyond (NASDAQ:BBBY) reported higher sales and higher revenues. Now I may not spend $299 for a device that cuts fruit and vegetables, but somebody out there is. I’m curious who has put that on their wedding registry.


Well, that’s the market in a nutshell from my eyes. We’re at a stall in the equity markets. The Energy and Industrial sectors continue to extend gains made earlier in the year while the material sector has been the best performer since the March 16th bottom relative to the S&P 500. Based on the sector rotation model, this seems to put the market smack near bull market status and early economic recovery. High-yield corporate bonds have outpaced investment grade and Treasuries. High yield corporate bonds have recovered from the March dip and are trading near their highs as represented by the iShares ETF proxy in HYG. Cash is trash. The retail, pharmaceutical, and biotech industry groups have broken to new highs and appear to be in play.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am generally long commodities and stocks