At the end of January, just as the stock market was making its first real pullback of the winter rally, John Murphy, chief technical analyst for StockCharts.com and president of the Murphy- Morris ETF Fund, was poised to publish a new book: Intermarket Analysis: Profiting from Global Market Relationships, an update to 1991’s Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets.

Murphy spoke with Active Trader about the economic interplay between bonds, stocks and commodities, and what their relationships portend for the future.

AT: Why did you decide to update the book?

JM: When I wrote the book back in 1991, the idea was to show how being aware of all these intermarket relationships added another layer of analysis and new market insights. And the principles that were laid out in that book held up pretty well — until the late 1990s. During 1997-1998 something very significant happened that started to change some of the intermarket relationships — mainly, the decoupling of bonds and stocks.

Historically, a basic intermarket principle had always been that rising bond prices and falling interest rates were normally considered bullish for stocks. But from 1998 until the second half of 2003, [bonds and stocks] moved in opposite directions. This was especially evident after 2000, during that three-year bear market. Bonds went through the roof, and the Fed lowered interest rates 12 times, but the stock market kept dropping.  

That change needed to be analyzed and explained. My feeling, which I explained in the new book, was during 1997-1998 the problems really came from Asia. It all started in the summer of 1997 with the Asian currency crisis, which lasted for almost a year. Interestingly, commodities collapsed during that period — the CRB index (the Reuters/Commodity Research Bureau index) fell to its lowest level in 20 years — and it was the first time I heard the word “deflation” used in my lifetime. Also, over the following year, bonds went up and became the strongest asset class — which wasn’t too surprising, because normally when commodities go down, bonds go up.

But it was surprising that stocks dropped so badly, and that got me thinking. The last time we saw anything like that was back in the 1930s when deflation was a problem. I felt global deflationary tendencies, mainly coming from Asia, were changing the bond-stock relationship. So the new book was designed to update the intermarket model.

AT: Do you think the more closely related moves in bonds and stocks since August or so of last year are just an aberration in the decoupling scenario, or are the markets becoming positively correlated again?

JM: There’s been a lot of discussion whether they’re recoupling or not. I kind of doubt it. First, stocks had a very strong second half in 2003; bonds were basically down during the second half of the year. I think a lot of the money still coming out of bonds is moving into stocks.

One of the things [I’m] watching very closely right now is the weak dollar vs. strong commodity prices. The normal historical pattern suggests that from this point interest rates should start moving higher and bond prices should go down. But we really haven’t seen too much evidence of that. It does look like bond yields bottomed last summer, but they’ve been fairly flat since then. It hasn’t really had a big impact on the stock market. I think what has to happen to put a cap on the stock market rally is an upturn in interest rates, and so far, we haven’t really seen that happening.

Another unusual thing is the relationship between commodities and stocks. In the past, strong commodity up moves traditionally have boosted inflation pressures, which would trigger a downturn in stocks. This happened in 1987, 1990 and 1994. This time around, however — and it comes back to deflation — if you look over the past year to year and a half, commodities and stocks have been moving up together.

My read on that is when the economy is coming out of a deflationary environment, which we haven’t seen since the 1930s, the Fed is trying to reflate the economy. This weakens the dollar and, in that environment, rising commodity prices are actually good for stocks because they’re indicative of economic growth and, also, they indicate deflation pressures are easing.

AT: What do you think will be the catalyst that finally drives the Fed to raise interest rates?

JM: I’m not certain what that might be. It could very well be we’d have to see some evidence of upward pressure in the inflation gauges — the CPI (consumer price index), the PPI (producer price index) — but so far they’ve been totally flat. I think the Fed is watching that very closely.

Also, there may be pressure from Europe. [Europeans are] becoming concerned about the strength of the euro. And the Japanese are letting the yen rise, but they’re still buying large amounts of dollars to try to keep it from going too far.

It’s unusual for the Fed to stay easy this long, but again, I think it is still a little concerned about deflation; the Fed wants to be absolutely sure it’s not a problem. But I think with the first uptick we get in some of these inflation gauges, which might occur later in the year, the Fed may come under more pressure to do something.

AT: What role does sector rotation play in your intermarket analysis?

JM: I’m very much a sector trader and [I] spend a lot of time analyzing stock market sectors — and that has a lot to do with the economic cycle. In the book I point out there is a very predictable sector rotation that goes on at certain stages of the business cycle. For example, at the very tail end of an economic cycle oil prices tend to go up near $40, the Fed tightens, and so on. That was textbook stuff back in 1999.

Normally, one of the signs the stock market is bottoming and the economy is turning up — and this was more evident a year ago than now — is where the leadership comes from. The two most prominent groups are small-cap stocks — which have led the market out of every recession since around 1960 — and technology stocks. When the Nasdaq is outperforming the broader market, that’s usually a good sign for the market.

AT: That was certainly the case in 2003.

JM: Yes. Another thing is that even within the stock market, one of the other effects of falling dollar and commodity prices is stocks tied to commodities do extraordinarily well. Gold stocks and precious metal stocks, for example, have been strong the past couple of years. Basic material stocks — which are things like copper stocks, aluminum stocks, and paper and forest product stocks — have also been strong over the past year, and I think that’s also tied to rising commodity prices.

One thing we’re a little concerned about right now — and this is not on a major scale — is we’re beginning to get overbought readings on some of these tech stocks, which means the technology rally might be getting a little tired.

AT: Tired as in a trend reversal, or tired as in a correction within the trend?

JM: Probably a consolidation or pullback of some type. Also, the Russell 2000 (the small-cap stock index) is testing its all-time high around 600, and there’s been a little loss of relative strength there. It’s very early on, but we’re watching for any signs of loss of leadership in those two groups.

But the most important thing is since the beginning of January, energy stocks have become extremely strong. Until now, energy prices haven’t really participated in this commodity rally. Prices have turned up, and over the past month there’s been a tremendous amount of money pouring into the whole energy sector, but oil service stocks in particular. This isn’t a major thing, but I’m just pointing out that, normally, when we see energy stocks showing market leadership, that’s very often associated with some corrective action in the stock market.

Also, from a seasonal standpoint the stock market is ending its three-month bulge — normally from November through January — and even in an uptrend. February tends to be a consolidation month. We’ve been suggesting to people if they’re looking for a reason to take a little money out of the market, this probably isn’t a bad time to do it.

But they could also rotate within the market — maybe take some money out of technology and rotate into some groups that did nothing last year and are just beginning to turn up. Energy is a perfect example. And telecom stocks — even health care stocks — are groups that just did not participate at all last year. I think there’s some rotation going on. I don’t know if it’s necessarily that bad for the stock market.

That’s what we’re looking for now: groups that are looking overextended. Technology certainly qualifies, and we’re rotating into groups that are just starting to turn up.

AT: Are there any things people should look out for later in the year as far as intermarket relationships go?

JM: Interest rates are the key this year. One thing people might want to watch within the stock market itself is interest-rate sensitive stocks — the banks, the brokers, insurance companies, even homebuilders to a certain extent — because these issues have been showing very good relative strength recently, which means the market at this point is not that concerned about interest rates.

Usually, when interest rates are starting to move up — actually, when the market believes interest rates are going to start moving up — we see selling in interest-rate sensitive stocks; they begin to lose leadership. We haven’t seen that yet.

When the banks and brokers start slipping relative to the rest of the market, that’s probably an indication interest rates are getting ready to rise, and that’s usually a sign of some kind of market top.

AT: Are there certain overseas markets or relationships that bear watching more than others?

JM: Overall, I’d keep a close watch on interest rates, Asia and the dollar. It’s interesting because Asia caused the problems in the first place, back in 1997- 1998. But, Asia has actually been leading us out of this deflation over the past year. China, of course, is the big reason — it’s driving global economic growth, although there are some concerns China is getting a little overheated. Also, it looks like Japan has bottomed. Asia was the strongest region in the world in 2003. What happens in Asia is largely driving what’s happening here.

Another benefit of a falling dollar is it makes overseas investments much more attractive, so I’d watch the dollar, too. If interest rates start moving up later in the year, I think that could very well call for a bottom in the dollar, which could make foreign investments a little less attractive to American investors.

BY MARK ETZKORN

©2004, reprinted with permission from Active Trader magazine.