|In 1998, the threat of deflation reared its ugly head for the first time since the 1930s, when stocks and bonds decoupled. It looks as if the old stock-bond relationship is returning to normal. Does it mean the worst is over? |
Deflation is relatively rare and occurs when the price of goods and services starts to fall. The most recent spiral began with the crash of the Thai baht in July 1997 after it floated the currency, which had been tied to the US dollar. This was followed by similar moves on the part of governments in the Philippines, Malaysia, and Indonesia. As a result, the Malaysian ringgit and the Filipino peso dropped 40%, the Thai baht 50%, and the Indonesian ruppiah 75% by the end of 1997.
The drop in buying power led to a collapse in commodity prices, which in turn hurt the economies of commodity exporters such as Canada, Australia, Mexico, and Russia. The ripple effect spread from there, eventually affecting the global economy. (Japan, the world's second largest economy, had been engaged in a deflationary spiral since its stock and real estate markets collapsed in 1989-90.)
An important part of understanding the business cycle, as described by Martin Pring and John Murphy, is the relationship between stocks and bonds. The business cycle starts with a rise in bond prices (as yields fall) as the economy begins to grow. Next, stock prices rise as companies and the consumers buying their products benefit from lower interest rates. As businesses ramp up production, commodity prices rise as more goods are manufactured.
As the economic cycle begins to mature and interest rates (yields) begin to rise due to inflationary pressures, bond prices begin to drop. The recovery starts to wane. As rates rise, money gets more expensive and stocks begin to drop. Finally, commodity prices drop as industrial production decreases. The economy heads for a period of contraction.
This relationship has existed through many business cycles over the years and has only been disrupted when deflation becomes a real threat. According to John Murphy in Intermarket Analysis, the first time this happened in North America during the 20th century was 1931-32, which was the transition from the 1929 stock market crash to the Great Depression, during which time consumer buying demand dropped off dramatically, and along with it the price of goods and services.
It happened again as the century was coming to a close in 1998 when deflationary pressures, resulting from the collapse of a number of currencies in Pacific Rim countries that became known as the "Asian flu," caused another stock-bond decoupling. Between July 1998 and early 2003, stocks and bonds began moving in opposite directions. The decoupling between stocks and bonds occurred in large part because investors, fleeing stock markets, sought the relative safety of US dollar-backed investment vehicles, driving bond prices up.
Larry Williams discusses how to take advantage of the normal stock-bond relationship in his book, The Right Stock At The Right Time — Prospering In The Coming Good Years, using J. Welles Wilder's volatility system. By taking an average of the top and bottom band, an average volatility band can be dropped into a chart (see magenta line in Figure 1).
Figure 1: Weekly chart of the Standard & Poor's 500 Index (SPX) and US Treasury Bonds (continuous) shows stocks and bonds moving in the same direction until July 1998, after which time they began moving in opposite directions. From April 2003, the old relationship appears to be returning to normal. The magenta line in the lower window market US Treasury bonds is the average of the top and bottom volatility index bands by J. Welles Wilder as described by Larry Williams, who uses the index on the bonds chart to trigger buy and sell signals for stocks.
MetaStock formula for Wilder volatility band average:
In a normal stock-bond relationship that existed up to July 1998, Williams looked to buy stocks or the Standard & Poor's index when bonds moved above the volatility band (lower window, Figure 1) and sell when it moved below. However, between August 1998 and April 2003, it did not work very well, and in fact, the trader who took trades in the opposite direction would have done better.
It appears that the normal relationship may be returning as evidenced by the fact that buying the S&P 500 index when bonds move above the volatility band and exiting when bonds move below the magenta line is looking as if it could be a profitable strategy once more.
Since only three trades have been generated so far, the results cannot be considered statistically significant. Using Kaufman's error ratio of 1 divided by the square root of the number of trades, the error of making an assumption based on three trades is huge at 58%. Once 10 trade signals have been taken, the error will drop to 32% and with 100 trades, to a more acceptable 10%.
Until there is more evidence that stocks and bonds have recoupled, it remains something to watch, but taking short index trades when bonds are moving up or vice versa is a strategy that could prove costly given the current market.
Matt Blackman is a trader, technical analysis, software reviewer, and content provider for technical trading/investment publications and websites. He is an affiliate member of the Market Technicians Association (MTA) and Canadian Society of Technical Analysts (CSTA), and is currently enrolled in the Chartered Market Technicians (CMT) program. He may be reached at firstname.lastname@example.org.
SUGGESTED READINGKaufman, Perry . Trading Systems And Methods, John Wiley & Sons.
Murphy, John . Intermarket Analysis, 2d ed., John Wiley & Sons.
Penn, David . "Gibson's Paradox," Working Money.com.
Pring, Martin J. . Technical Analysis Explained, McGraw-Hill.
Williams, Larry . The Right Stock At The Right Time Prospering In The Coming Good Years, John Wiley & Sons.
Charts courtesty MetaStock (Equis International)
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.