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Technical analysts have traditionally looked at the price action of the averages along with market breadth, momentum and sentiment to identify major trend reversals in the stock market. In recent years some of us have also started looking at intermarket relationships as a means of providing additional clues.
The Stock/Commodity RatioIt is a well-known fact that equities do not like rising commodity prices, yet there are periods when both rise simultaneously. The last couple of years are a testament to this, as we have seen a steady rise in commodity prices which reflected an advancing economy. Since this also implies an expansion in profits, the stock market has gone along with the buoyant commodity prices. It will continue to do so until it senses that the commodity bull market will result in an overheated economy.In effect, equities enjoy rising commodity prices just like a partygoer appreciates a cocktail or two. However, in both cases, too much of a good thing inevitably leads to trouble. The trick is to find out when the tension becomes too great. The technique I use is to create a ratio by dividing the S&P Composite by the CRB Spot Raw Industrials and using the KST (momentum) of this relationship for the buy and sell signals for the market. The first chart below explains how this works. The two sine curves represent the path of stocks and commodities over the course of a typical business cycle. Since stocks lead commodities, they are the first to top out. Note the heavier solid plot highlights the turning points. Just prior to the peak, the dashed blue stock line starts to slow down. At the same time, upside commodity momentum continues unabated.
This means that the ratio between the two will often peak out ahead of the actual top in the stock market. At the bottom, things reverse, because equities slowly reverse to the upside as downside commodity momentum remains strong. Consequently, the ratio bottoms, and a buy signal for equities is triggered. It doesn't work out this perfectly in the real world, of course, but over the last 50 years the signals have been reasonably reliable. The next chart replays the record over the last 10 years. The upward and downward pointing arrows show those periods when the long-term KST of the ratio crosses above and below its moving average. These have been pretty timely signals but have only offered a general warning of an impending equity reversal. Actual buy and sell signals really require confirmation from the S&P itself. In most cases, it is possible to construct a trend line and observe its violation, or at the very least wait for a 12-month moving average crossover.
The ratio peaked some time ago, but the KST has only just crossed marginally below its average. The ratio itself has also tentatively penetrated its up trend line going back to 2002, which obviously suggests that it is going lower. To be sure, though, I would like to see a more decisive signal to place the issue beyond reasonable doubt. If past is prologue, it would then set the scene for a decline in equity prices. The key will be to see if the S&P confirms with a trend line break and 12-month moving average crossover. For the record, both series are currently around 1250. Nasdaq 100 Vs. the DowSeveral weeks ago I wrote about how the ratio of the Dow to the Nasdaq 100 looked as if it might be about to experience an important breakout in favor of the Dow. The breakout at 6.80 has not yet happened, but it is very close.The piece was written as a way in which investors might more safely play the market regardless of whether it went up or down. Since then, I have done further research and discovered that the relationship itself has offered timely and reliable signals for the market as a whole. The next chart shows the S&P in the top panel and the ratio in the lower one. Since I wanted movements in the ratio to correspond with those in the S&P, I have reversed it -- instead of dividing the Dow by the Nasdaq 100, the Nasdaq 100 is divided by the Dow.
It's obvious that the ratio moves fairly closely with price movements in the S&P. The rationale is that the Dow is constructed from fairly conservative blue chips that pay a relatively high dividend. Investors therefore turn to Dow components when they are in a cautious, defensive mood. On the other hand, stocks in the Nasdaq 100 tend to be more speculative in nature, and market participants favor them when confidence is high and rising. Right now, the ratio is sitting on a very important up trend line and its 12-month moving average, and it is probably on the verge of giving a sell signal. We can also see this from the next chart, which shows the whole picture in greater detail. Once again, the ratio is right on the trend line and its 65-week Exponential Average (EMA). The intermediate KST, which monitors price movements of between two to nine months, is declining. This indicates that downward pressure is already being applied. I must emphasize that a break has not yet occurred, but if one does, it would strongly suggest extended weakness in the ratio. Based on past action, if that happens, the break would confirm signs of general market vulnerability that are being triggered by other important intermarket relationships.
At the time of publication, Pring had a position in the Dow/Nasdaq-100 spread, although holdings can change at any time. Martin J. Pring is president of pring.com, and is actively involved in Pring Turner Capital Group, a money management firm. He also publishes the monthly market letter "Intermarket Review." Pring is the author of several books, including Technical Analysis Explained, and numerous educational, interactive CDs. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Pring appreciates your feedback; click here to send him an email.
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