February 16, 2010

Business Cycle Analysis Study

(Click to enlarge the graphic).

Market volatility is picking up in equities - but if business cycle analysis is to hold true to form, what if anything is going on in commodities?

The 6 charts above represent (left to right, weekly bars above, daily bars below) bonds (blue, ticker IEF), stocks (purple, ticker SPY), and commodities (gold, ticker DBC). Black lines in the lower half of each chart are relative strength plots to the "next" asset class, with the divisor in grey being (again, left to right) stocks, then commodities, and finally bonds. Hence, the black lines represent (left to right) bonds to stocks, stocks to commodities, and commodities to bonds. Lastly, red vertical dashed lines denote dates of interest, and heavy black trend lines are plotted in each relative strength area.

In the idealized business cycle, bonds rise, followed by stocks, then commodities. At some point, the process reverses - bonds fall, followed by stocks, then commodities. Theoretically, bonds rise due to falling interest rates. Falling interest rates result from accommodative policy. A natural inflation occurs where yields precipitate favoring riskier investments (stocks). Add to the mix many securities positions may be levered using margin, and lower carrying costs resulting from accommodative policy induce an added inflationary effect to equities. As business expands, demand for goods and services spills over into competitive pricing for materials, and a rise in commodities ensues. Somewhere along the way, policy becomes less accommodative as rates rise to combat inflation.

This analysis fails to make a simple yet elegant point: any of these 3 asset classes can be rising or falling at any given time. For example, the following "flow" exists:

• bonds rising, stocks falling, commodities falling
• bonds rising, stocks rising, commodities falling
• bonds rising, stocks rising, commodities rising
• bonds falling, stocks rising, commodities rising
• bonds falling, stocks falling, commodities rising
• bonds falling, stocks falling, commodities falling

While rarely anticipated, let alone to the degree expected, the last circumstance can happen - few need look further than Fall 08.

Beginning top left, an uptrend break in relative strength signaled favoring equities over bonds in early Apr 09. That departure from "flight to safety" proved to be the real deal as evidenced by the phenomenal run in stocks since; as money flowed into stocks, bonds fell along the mid and long part of the curve. Moving top center, stocks climbed until giving way to favoring commodities in Oct 09. This came against the backdrop of commodities being favored over bonds some 5 months after the shift into equities.

Given the events of the preceding paragraph, a closer look at the bottom row (daily charts) tells an interesting story - the move to commodities does not yet appear to have materialized. Before reviewing the daily charts, note upper right that commodities have managed only to drift higher following their precipitous drop. While there have been some winners, the complex itself has truly waned. While most look to the usual suspect and find crude has drifted similarly, agricultural commodities as a whole in particular have gone almost nowhere. Demand just does not appear to be following the rise in equities.

So what of the daily charts? First, note lower left bonds have been favored over equities since Feb 10. Given the past few weeks' activity, this is of little surprise. Lower center, commodities have been favored over equities since Dec 09, which would be a natural progression of the business cycle. Lower right, however, commodities are sending mixed signals with their favor over bonds short lived from Dec 09 - Jan 10. This technically begs the question - will we see an inflation based move in commodities?

Conversation as to the current state of accommodative policy has, in recent weeks, exhibited volatility in the fundamental sense. Countless banks received capital injections that if released into circulation would surely create a circumstance under which commodities could soar. The Fed truly has a difficult challenge on its hand as to how these Dollars are recouped. Politically, mixed signals abound as to the need to increase lending which would certainly release Dollars into general circulation. That same act would logically keep interest rates low, with the two circumstances combined leading to inflation... and commodities soaring in the aftermath.

Alternatively, if the Fed successfully withdraws funds injected into the banking system, rates should in fact rise, the Dollar continue its recovery, and commodities languish. This would be the straw that breaks the back of what has been an incredible advance in bonds at the short end of the curve, with 2 year treasuries rising unabated for months. Technicians should look for clues in the relative strength of the aforementioned pairs for clues in coming weeks as the clock appears to be ticking on Fed action.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

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