12, 2007 -- One of my favorite market analysts is John J. Murphy, author of several best selling books, including Technical Analysis of the Financial Markets, which is regarded as the standard reference in the field. Mr. Murphy is also a former technical analyst for CNBC and has over 35 years of market experience. Stocks & Commodities in the October 2002 issue described his intermarket work as, "unparalleled."
Intermarket analysis is based on the premise that all markets are linked. Those that have followed my writings over the years know full well that I embrace wholeheartedly that assumption. Many of my market columns have been based on the idea that a market movement one place would impact markets elsewhere. Some markets are leaders, others followers. That is what intermarket analysis reveals.
Not long ago, Mr. Murphy wrote an article titled, "The Link Between Bonds and Stocks." The article examined the relationship between the two markets and showed clearly how bond prices can be used as a leading indicator for stocks. Here are just a few highlights from Mr. Murphys analysis: "Bonds and stocks usually trend in the same direction. However, it's not as simple as that. At important turning points, bond prices usually turn ahead of stocks. At bottoms, bond prices usually turn up before stocks. At tops, bond prices usually turn down before stocks. Viewed in that fashion, bond prices can be used as a leading indicator for stock prices." In the same article he states, "The tendency for bond prices to turn ahead of stocks also explains the apparent "decoupling" that often occurs when bonds and stocks trend in different directions. What may appear to some to be a "decoupling" is an early warning to others who are aware of the interrelationship between the two. A dramatic example of that phenomenon
occurred in 1987, when bonds plunged during April (coinciding with a strong upturn in commodity prices), four months before the August peak in stocks."
In 1987, bond prices were slipping badly due to rising commodity prices and fears of inflation. The stock market ignored those warning signs for some time but on October 19, 1987, 20 years ago this week, reality sank in and the Dow plunged nearly 23 percent on what is now referred to as, Black Monday.
The intermarket relationships in '87, the formula that led up to Black Monday was this; a rise in commodity prices, a drop on bond prices that in turn a sharp sell off with the Dow. That was the formula for the stock market disaster that took place in October 1987.
Lets now examine how the stock and bond markets have performed since the summer of '07. While doing so, keep in mind Mr. Murphy's assumptions; stocks and bonds usually trend in the same direction; bond prices usually turn ahead of stocks. And most important; bonds are a leading indictor for stocks.
In mid June, Treasury bond futures were down to 105, in August had improved to nearly 109 and in early September were a tad over 114. However, prices ended this week at a bit over 110, a two month low. Dow Jones futures on the other hand had dropped to a 4 month low in mid August, touching 12700 but quickly bottomed and turned higher following the rally taking place with bonds. And this week, Dow futures closed at 14179, a few points from an all time historic high. The Dow has held up well even though bond prices have turned lower.
This week ended with bond prices at a two month low, stocks their highest level in history, gold at a 28 year high, crude oil at an all time historic high and the CRB index, a gauge of commodity prices within reach of its best level in history. It is a scenario eerily similar to that witnessed in the Fall of '87!
Some, as Mr. Murphy claims, view stocks and bonds moving opposite as nothing more than "decoupling" and think little of it. Others (me!) that are aware of the intermarket relationship between stocks and bonds view the divorce between the two markets as an early warning sign, a bearish omen for stocks IF bond prices continue to fall much lower.
Will bond prices continue lower from this point? They will if commodity prices continue upward because that is the intermarket relationship between those two markets. Commodity prices and bond prices tend to move opposite each other. If commodities continue to rise, bonds should weaken and stocks follow.
(The information in this article is the opinion of Commodity Insight's Jerry Welch and subject to change without notice.)