IntermarketAnalysis

Profiting from Global Market Relationships

JOHN MURPHY

John Wiley & Sons, Inc.

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IntermarketAnalysis

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Founded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With offices in North America, Europe, Aus-tralia, and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers professionaland personal knowledge and understanding.

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IntermarketAnalysis

Profiting from Global Market Relationships

JOHN MURPHY

John Wiley & Sons, Inc.

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Copyright 2004 by John Murphy. All rights reserved.

Some of the figures in Chapters 1, 2, and 3 were created by Knight Ridders Tradecenter.Tradecenter is a registered trademark of Knight Ridders Financial Information.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

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http://www.copyright.comhttp://www.wiley.com

To Anne, a great poet

and

to Tim, a great brother

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vii

Acknowledgments ix

Introduction to Intermarket Analysis xi

1. A Review of the 1980s 1

2. 1990 and the First Persian Gulf War 17

3. The Stealth Bear Market of 1994 33

4. The 1997 Asian Currency Crisis and Deflation 51

5. 1999 Intermarket Trends Leading to Market Top 65

6. Review of Intermarket Principles 81

7. The NASDAQ Bubble Bursts in 2000 97

8. Intermarket Picture in Spring 2003 115

9. Falling Dollar During 2002 Boosts Commodities 131

10. Shifting from Paper to Hard Assets 145

11. Futures Markets and Asset Allocation 159

12. Intermarket Analysis and the Business Cycle 179

13. The Impact of the Business Cycle on Market Sectors 199

14. Diversifying with Real Estate 217

15. Thinking Globally 235

Appendix 247

Index 263

Contents

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ix

Iowe thanks to a lot of people who helped put this book together: Pamelavan Giessen, Executive Editor at Wiley, for talking me into doing it in thefirst place; Jennifer MacDonald and Joanna Pomeranz for making surethat everything wound up in the right place; Heidi Shelton and Pete Behmerat Stockcharts.com for producing great looking charts; John Carder atTopline Investment Graphics for his innovative historical charts; Tim Murphyfor his help with the cover design and computer graphics; those market ana-lysts who generously allowed me to draw from their work including NedDavis, Ken Fisher, Ian Gordon, Martin Pring, and Sam Stovall. And, finally,the McTooles family who kept my spirits up while I was writing this book.

Acknowledgments

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xi

In 1990, I completed a book entitled Intermarket Technical Analysis:Trading Strategies for the Global Stock, Bond, Commodity, and Cur-rency Markets. My point in writing it was to show how closely related allthe financial markets really are, both domestically and internationally. Thebooks main thesis was that technical analysts need to broaden their chartfocus to take these intermarket correlations into consideration. Analysis ofthe stock market, for example, without consideration of existing trends in thedollar, bond, and commodity markets was simply incomplete. The book sug-gested that financial markets can be used as leading indicators of other mar-kets and, at times, confirming indicators of related markets. Because themessage of my earlier text challenged the single market focus of the techni-cal community, some questioned whether this newer approach had any placein the technical field. Many questioned whether intermarket relationshipsexisted at alland whether they could be used in the forecasting process. Theidea that global markets are linked to each other was also viewed with someskepticism. How things have changed in just one decade.

Intermarket analysis is now considered a branch of technical analysis andis becoming increasingly popular. The Journal of Technical Analysis (SummerAutumn 2002) asked the membership of the Market Technicians Association torate the relative importance of technical disciplines for an academic course ontechnical analysis. Of the fourteen disciplines included in the poll, intermarketanalysis ranked fifth. Intermarket work has come a long way in ten years.

EARLIER BOOK COVERED THE 1980s

My earlier text focused on events in the 1980s starting with the end of thecommodity bubble at the start of that decade. This ended the hyperinflation of

Introductionto Intermarket

Analysis

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xii INTRODUCTION

the 1970s when hard assets like commodities soared and paper assets (likebonds and stocks) soured. The 1980 peak in commodities ushered in a two-decade disinflationary trend that coincided with major bull markets in bondsand stocks. The biggest financial event of the 1980sthe 1987 stock marketcrashprovided a textbook example of how markets are related to eachother and the necessity for paying attention to those related markets. A surgein commodity pricesand a collapse in bond pricesduring the first half of1987 gave ample warning of an impending stock market decline during thatyears second half. Three years later during 1990, as the previous book wasgoing to press, global financial markets were just starting to react to Iraqsinvasion of Kuwait in August of that year. Gold and oil prices surgedwhilestock markets around the world fell. Interestingly, thirteen years later (at thestart of 2003), market observers were facing the prospect of another Iraq warand were studying anew the 19901991 market reactions to look for parallels.History has a way of repeating itself, even in intermarket work.

JAPANESE BUBBLE BURSTS IN 1990

Another important event which happened at the start of 1990 is still havingglobal repercussions more than a decade later. The bubble in the Japanesestock market burst. This started a thirteen-year descent in that market (whichrepresented the worlds second largest economy) that turned into a defla-tion (a decline in the prices of goods and services). Over a decade later, west-ern central bankers were studying the Japanese deflation model to find waysto combat increasing signs of deflation in western economies. Some of thecharts presented in this book also bolster the view that Japanese deflationwas one of the major contributing factors to the decoupling of bonds andstocks in the United States years later when rising bond prices starting in2000 coincided with falling stock prices.

THIRD ANNIVERSARY OF 2000 MARKET TOP

March 10, 2003 marked the third anniversary of the ending of the Nasdaqbubble that signaled the start of the worst bear market in decades. A 50 per-cent decline in the S&P 500 was the worst since 1974. The Nasdaqs loss of 78percent was the worst since the stock market crash from 19291932 in themidst of the Great Depression. Market historians had to go back to study

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these two periods to gain some insight into market behavior. What madecomparisons between these two earlier periods complicated was that each ofthem was caused by a different economic event. The bear market in stocksduring the 1970s was associated with a period of rising commodity pricesand hyperinflation. The bear market of the 1930s, however, was associatedwith a period of economic deflation. While both situations are bad for stocks,deflation is the more difficult to counter.

Starting in 1998, the word deflation was being heard for the first timesince the 1930s. This happened as a result of the Asian currency crisis thatgripped the world during 1997 and 1998. Within five years, global deflationhad spread from Asia and was starting to infect global bond and stock mar-kets everywhereincluding the United States. More than any other factor,the reappearance of deflation changed intermarket relationships that hadexisted over the prior forty years. These changes are why I am writing thisbookto show what has worked according to the older intermarket modeland, more importantly, what has changed. Intermarket analysis is based onrelationships (or correlations) between markets. It is not, however, a staticmodel. Correlations between financial markets can change over time. Theydo not change randomly, however; there is usually a good reason. The mainreason for some of the changes that started in the late 1990s was the growingthreat of deflation.

THE DEFLATION SCENARIO

In the 1999 revision of my book Technical Analysis of the Financial Mar-kets, I included a chapter on intermarket analysis which reviewed the historicrelationships that had been working for several decades. I also added a newsection which was entitled Deflation Scenario. This section described thecollapse in Asian currency and stock markets starting in the middle of 1997;the severe decline had an especially depressing effect on global commoditymarkets like copper, gold, and oil. For the first time in generations, analystsstarting expressing concern that a beneficial era of disinflation (when pricesare rising at a slower rate) might turn into a harmful deflation (when prices ofgoods actually fall). How the markets reacted to that initial threat of deflationdefined the intermarket model for the next five years. Commodity prices fellwhile bond prices rose. This was nothing newfalling commodity pricesusually produce higher bond prices. What changed, though, was the relation-ship between bonds and stocks. During 1998, stocks were sold all over theworld while money poured into U.S. Treasury bonds in a global search for

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