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Using Commodity Prices to Identify Secular and Cyclical Trends in Equity Prices And Why Its Bearish Now

Unusual Changes in Commodity Prices and Secular Bear Markets in Equities

A principal driver of secular trends in equites is long term mood swings in investor sentiment. However, its also a fact that secular bear markets in inflation adjusted equities develop when commodity prices, on a trend basis, experience unusual volatility. Given the default policy of central banks to resort to monetary expansion at the slightest sign of trouble, this volatility is usually experienced on the upside, although there are instances when downside instability in commodity prices has been responsible for specific phases of secular bear markets. The most notorious of these was the 1929-32 down leg in the 1929-49 secular bear. This commodity/equity relationship is featured in Chart 1, where the upper panel contains real stock prices since 1871 and the center window displays commodity prices. (We prefer to use CPI adjusted equities since it not only emphasises greater cyclicality, but more accurately reflects investors true experience.) If inflation eats away at the true purchasing value of equity gains, then they are not gains at all, merely an illusion. Secular equity bear markets since 1850 are flagged with the dashed red arrows. It is fairly evident that all of these major price setbacks were associated with a background of rising commodity prices. The relationship is not an exact tick-by-tick correlation, but the chart nevertheless demonstrates that a sustained trend of rising commodity prices will sooner or later result in the demise of equities. As cited earlier, the one major exception to this relationship, between 1929 and 1932, was caused by instability of a different sort, and that was where commodity prices experienced unusual downside volatility. After that, the nature of the game changed and it was sharply rising commodities that resulted in an extension to the secular bear. In a sense, the 1929-49 secular bear can be split into two parts. The first caused by excessive commodity deflation and the second by excessive inflation. From 1949 until the mid-1960s, commodities experienced a trading range and equities a secular bull market. The thick 1

solid green arrows show that a sustained trend of gently falling or stable commodity prices is positive for equities.

Inflation Adjusted Stock Prices versus Industrial Commodities

Chart 1

All four secular bulls developed under such an environment. This point is also underscored by the opening decade of the last century. It has been labeled a Secular Bear, but real equity prices were initially quite stable as they were able to shrug off the gentle rise in commodities. Only when they accelerated to the upside a few years later because of World War I did inflation adjusted stock prices sell off sharply. A useful approach for identifying a secular peak in commodity prices and therefore secular low in equities is to calculate a price oscillator or trend deviation measure. In this case, the parameters used are a 24-month (2-year) simple moving average divided by a 240month (20-year ) average. The downward pointing arrows indicate that reversals from an overextended position have offered four reliable signals in the last 150 years or so. 2

The oscillator also peaked in 1975 but this proved to be a temporary respite for both the secular equity bear and the commodity bull market. The indicator hesitated in 2008, but has once again extended its rally to a new high, thereby confirming that the secular uptrend is still intact. Not so, with the primary trend, which is now bearish.

Real Stock Prices versus Commodity Momentum

Chart 2

Chart 2 compares real stock prices to a momentum measurement for commodity prices and further supports the idea that rapidly moving commodity prices in either direction are bearish for stocks. The indicator itself expresses how each monthly level in the commodity index deviates from its 18-month moving average, so it is more of a business cycle associated barometer for equity prices than a secular one. A high reading indicates when the index is substantially above its 18-month moving average and vice versa. This relationship demonstrates that sharp commodity momentum rallies that develop from an extreme oversold condition are actually bullish for equities because they signify a recovery coming out of a deep recession. Other than that, unusually large 3

swings in commodity prices adversely affect equities. The shaded areas point up the greatest fluctuations, which have also been associated with the worst equity bear markets in the last 100 years or so. The arrows indicate when the oscillator comes close to, or briefly touches, the -10% level and reverses to the upside. You can see that these events are usually associated with a bear market low or a quick, but nasty, shakeout such as that that developed in 1998. If you never appreciated the fact that equity prices generally abhor instability, this chart brings you up-to-speed!

Quantifying Dangerous Commodity Instability

The approach taken in Charts 1 and 2 clearly demonstrates the broad connection between real stock price declines and unstable commodity prices. However, the missing ingredient is a more precise approach that we could use to identify positive and negative equity environments during the course of the business cycle.

Real Stock Prices versus Commodity Momentum

Chart 3

Chart 3, for instance, takes a slightly different track because it actually measures environments of cyclical equity risk and flags them with the red highlights. This is useful as a tactical device for allocating assets over the course of the business cycle. In addition, it quantifies the type of commodity instability being experienced and therefore aids us in our quest to better appreciate whether the environment is approaching a destabilizing commodity rally or a disrupting decline. In this respect, our approach is to adopt a model that takes three factors into consideration and also defines them. They are: 1. Dangerous periods of upside commodity volatility. 2. Treacherous environments of declining commodity prices. 3. A form of trend measurement that confirms whether equities are responding in a negative way to the defined environment. When either volatility condition is confirmed by the trend measure or the trend measure on its own is negative, it is assumed that equities are risky and should be avoided. By the same token, if the trend is positive and neither volatility condition is in force, this signals the OK to invest in equities. The ingredients for the actual model are featured in Charts 4 and 5. The first covers the bulk of the period since 1870 and the second embraces more recent price action. Red highlights indicate when bearish periods are identified by the model. These negative signals for inflation adjusted stocks develop when two of three conditions are in force. First, when the 9-month ROC for deflated equities and commodities are both below zero. In this case, negative commodity momentum indicates a weak economy and the bearish negative equity velocity confirms that stock prices are responding to it. Its also a way of showing that downside commodity instability is sufficient to have an adverse effect on stocks. If it werent, then stocks would not be experiencing negative momentum.

Real Stock Prices versus The Commodity/Stock Model

Chart 4

Real Stock Prices versus The Commodity/Stock Model

Chart 5

Our second condition attempts to monitor situations when upside commodity momentum is excessive and therefore is likely to harm stocks. For example, we know that a gentle rise in commodity prices is positive for equities because it reflects the fact that the economy is growing, but not in an overheated way. However, when commodity prices accelerate to the upside and stocks fail to respond, it is a signal that equities have started to factor in these inflationary pressures in a negative way. Stocks are a forward looking indicator, so their reluctance to follow commodity prices higher means they are anticipating that these end of cycle pressures will soon end in an economic contraction. Our model measures this condition by subtracting a specified rate of change for inflation adjusted equities from that of commodities. When the differential exceeds 21%, the second unstable commodity condition is met. It remains in force until a reading below 21% materializes. The final model ingredient is that the deflated stock series must confirm the condition being signaled by its other two components. In other words, if either of the conditions is bearish, then deflated equities must also be below their 9-month MA. We can use the model from two points of view. First, the shaded areas in Chart 3 show the secular bear markets that have evolved since the mid-nineteenth century. The red highlights indicate when the model was bearish; and it is fairly obvious that the indicated setbacks, for the most part, were pretty severe. The good news is that the model caught most of these declines. Secular bulls also experience primary trend declines but these are far more benign. The model catches most of them, but because of their short-lived nature, its usually a bit late in signaling the all clear. The moral of the story is that if a secular bull is in force, investors are quickly bailed out; so the model does not deserve as much respect when on a sell signal. On the other hand, in a secular bear, sell signals indicate a much more risky environment, so those who ignore it do so at their peril. The second way in which this approach can be used is to help form a cyclical allocation strategy. By and large an overweight position in equities would be appropriate when the model bullish whereas a trimmed down position would make more sense when it is negative. 7

S&P Composite versus the Equity Line for the Commodity/Stock Model

Chart 6

The upper window in Chart 6 shows the equity line for the system using a fully invested position when the model bullish (green highlight) and no exposure during bearish periods (red highlight). An original investment of $1,000 would have returned over $250,000 over the 130 years. This assumes the receipt of a paltry 3% interest rate when out of the market (the average was 4.4%), but makes no allowance for commissions or slippage for the 104 trades. A buy/hold approach during the same period returned a $125,000 gain with far greater risk exposure. When using the CPI adjusted series, the profits were, of course, much less at $67,000. However the comparison against the $13,000 buy/hold approach was far superioran approximate quintruple in the difference between the two results compared to a doubling for the absolute comparison. The model is currently bearish, not because of excessive inflation but due to the fact that both commodity ROCs are negative and the deflated S&P is below its 9-month MA. Unfortunately, there is no way of knowing how long this condition will last. All we 8

can say is that pretty well all the evidence at our disposal points to a secular bear market. Remember that is the kind of environment where risks of a prolonged cyclical bear are, as they say, elevated.

Martin J. Pring