As you begin to understand the gears of the economic machine, the logical progression of top-down analysis is to relate economic forces to the market and stocks you trade. Many of the influences we have studied thus far will have varying degrees of impact during the business cycle. There are times when economic news has little impact on the prevailing trend and other times when the market seems to stand still until the Fed speaks. The point here is that while the gears of the machine can seem complex and inconsistent in relation to market trend, the understanding of economic influences will contribute to market analysis.
This chapter is a strong step in that direction. Sector analysis is specific to market analysis, yet it is important to remember the foundation we have built so far. The previous chapter outlined the effects of short-term interest rates on securities and the basics of commodity contacts. This chapter helps you analyze which sectors are most influenced by such events. In the simplest context, sectors that stand the most to gain by interest rate changes tend to lead markets and sectors that are hit the hardest when rates rise tend to lag the market. Traders want to buy leading sectors in bull markets and sell (short) weak sectors in bear markets. This is a simple concept that has given traders the edge for many years.
Sector analysis involves focusing on a particular industry or sector of the economy. This can range from industry-related sectors such as software, technology, and drug manufacturing to economic influences such as banking, utilities, currencies, and real estate. The range is broad but the component issues within each are defined by the sector. The impact of broad market influences help narrow the search where participants should likely expect reaction. For example, a significant move in the bond market, as discussed in Chapter 3, allows the possibility of interest-rate sensitive issues to have reactionary moves (Freddie Mac and Fannie Mae). Therefore, it would make sense to focus on the banking sector for relatively strong (longs) or weak (shorts) issues. Moreover, there are certain sectors of the market that have historically been shown to be a leading indicator to the overall markets, such as the Dow Jones Utility Average and the Amex Oil Index.
The Dow Jones Utility Average (UTY) debuted in January 1929, making it the youngest of the three Dow Jones Averages. This capitalization-weighted index, composed of 19 geographically diverse public utility stocks listed on the New York Stock Exchange (NYSE), has traditionally provided a haven for investors who fear recession and unstable returns on other investments (these issues tend to pay high cash dividends). In theory, a rise in utility stock prices indicates investors anticipate falling interest rates, since utility companies are big borrowers and their profits are enhanced by lower interest costs. Conversely, the utility average tends to decline when investors expect rising interest rates. Due to the index’s interest-rate sensitivity, the utility average is regarded by many as a leading indicator for the stock market as a whole.
With regard to the Dow Utilities as a leading indicator of equities, the correlations have become clear since 1972. In November of that year, the utilities peaked a few months before the Dow, and then formed a bottom just 10 months later, leading the Dow. Moreover, the utilities peaked in the beginning of 1981, while the blue chips formed a high only three months later. These similarities continued in 1982, with both averages bottoming and rallying together until August 1987. From an investor’s point of view, the correlations since 1972 have been remarkable.
Research found in Technical Trends by John R. McGinley, Jr. has shown that the Dow Utilities has led the Dow Jones at every peak since 1960 with only a few exceptions (most notably the 1977 peak). When looking at lead times, on average the Utility Index peaked three months prior, with a variance of one to ten months. Relatively speaking, that is not a bad track record at all.
The other index that has historically shown itself to be a leading indicator to the overall markets is the Amex Oil Index (XOI), a price-weighted index comprised of companies involved in the exploration, production, and development of petroleum. The XOI Index was established with a benchmark value of 125.00 on August 27, 1984. The theory of the index holds that higher oil prices become inflationary, and this in turn has negative implications on the Dow. However, just like with Fed fund hikes, the Dow can trade in step with higher oil prices for quite some time before inflation is perceived by investors to be out of control. This is an important caution since cheap oil prices do not necessarily mean good news for the Dow Jones Industrial Average.
Remember, oil is considered an import product; therefore, cheap oil has the tendency to bankrupt small oil producers and oil equipment companies, especially those in the U.S. These companies usually only make a profit if oil prices are at least $16 to $18 a barrel. Cheap oil increases dependence on foreign oil imports, resulting in larger trade deficits. More importantly, cheap oil historically results in significant job loss in oil and related industries in the U.S. Several studies indicate there is a negative correlation between the fluctuations in the oil price and the gross national product of Western countries. From 1982 to 1986 when oil prices were high, the economies of the U.S., Japan, and Western Europe were expanding, whereas in the second half of 1980s, when prices collapsed, a recession took place. These are important representations of the global economy as well.
Since the U.S. dollar is the de facto global reserve currency, its trading behavior is exceedingly important for investors and speculators around the world to monitor. To monitor the U.S. dollar is to watch the U.S. Dollar Index. This U.S. Dollar Index is a futures contract that trades on the New York Board of Trade. Futures traders and futures-options speculators around the globe relentlessly trade these U.S. Dollar Index futures contracts to actively speculate on the U.S. dollar.
The U.S. Dollar Index compares the U.S. dollar to a basket of global currencies rather than just one. As of this printing, the Dollar Index consists of a trade-weighted geometric average of seven currencies, including the European euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. (Note: There is a chance that within a few years the Chinese yuan will be included, especially if the massive emerging economic power of China is combined with the world’s first major gold-backed currency in decades. A golden yuan could rapidly dominate Pacific and Asian trade and it would be hard not to include it in the U.S. Dollar Index.) See Figure 4-1.
FIGURE 4 - 1 A weekly chart of the U.S. Dollar Index.
There are a number of important factors to consider when looking at the overall health of the U.S. economy and the U.S. dollar. For example, the United States’ trade balance can have an effect on the economy and the value of the dollar in relation to foreign currencies. Since changes in a country’s economy affect stock prices, it is important for us as traders and investors to understand this relationship. For example, in 1987 the “Asian Flu,” as it was known, was named for the economic “bug” that began with currency (Baht) and spread from country to country, infecting otherwise healthy economies with weakened currencies, sudden credit defaults, and extreme stock market volatility.
We incur a trade deficit with a foreign country when we import more goods than we export. To import goods from other countries, we need to exchange our dollars into their currency in order to buy their goods. This is the process. If the foreign country doesn’t want as much of our goods, then they won’t need to exchange as much of their currency for our dollars. That causes an oversupply of dollars in the exchange market and leads to a fall in the exchange rate. In relative terms, we would say the dollar is “weak.” On the other hand a strong economy can make the dollar “strong” (raise the exchange rate) in spite of a trade deficit. The reason is that a strong economy attracts investment capital from abroad and foreign countries need to exchange their currencies for dollars to invest in the U.S. This is where the U.S. stock market can help absorb trade deficits. This drives up the demand for the dollar, resulting in a stronger currency. Exporting more than we import (trade surplus), coupled with a strong market, substantially strengthens the dollar. Many believe that as the world leader in technology development, the culmination of our trade surplus in technology, coupled with its impact on the U.S. stock market, drove exponential growth to the dollar as well as the equity markets. Many also fear that becoming uncompetitive in technology could be devastating to the U.S. economy. California, one of the world’s largest economies overall (countries included), has shown signs of losing competitiveness in technology (Silicon Valley, etc.). This could be a wake-up call or a foreteller of the future.
Trade deficits or surpluses are important because they give us clues as to the direction of the dollar and the stock market. A rising dollar combined with a booming economy in the U.S. and weakening economies in Asia attracts investment and drives up our stock market. Rising trade deficits put downward pressure on the dollar and mean that American businesses are having trouble competing abroad, both of which can cause foreign and domestic investors to put their money elsewhere. The most important feature of the world economy is that money is always on the lookout for a better home. This is true domestically and abroad. Capital generally flows worldwide to where the prospects of return relative to risk are the greatest. The best tip to mastering the economics is to constantly think about all the investment alternatives available worldwide. Be aware that anytime liquid investments look relatively better, it will attract money (money flow) from all over the world and bring down the prices of the relatively less-profitable alternatives. The huge waves of Asian money that flowed into the U.S. financial markets in 1997 and 1998 will flow back out along with American money, riding the wave as soon as the trend in the yen and Asian economies looks better than the trend in America!
The dollar’s high correlation with the U.S. equity markets is very interesting, hitting highs and lows with the S&P 500 many times over the years in tandem. When foreign investors seek to put their surplus capital in the U.S. as an investment, the primary destination of this capital is most likely the U.S. stock and bond markets (main two sprockets). When stocks are going up and euphoria exists, demand for dollars increases as foreign investors sell their local currencies to buy dollars in order to buy U.S. stocks. Therefore, increased dollar demand drives up the international price of the U.S. dollar. The reverse is true as well. As foreign investors already invested in the U.S. equity markets watch the U.S. stock indices fall, foreign investors not only face equity losses but currency translation losses as well. So, as the stock markets fall, foreign investors want out so they sell their U.S. stocks for dollars and then sell these dollars to buy back into their own local currencies. Therefore, increased dollar supply drives down the international price of the U.S. dollar.
For example, American investors could be down 5 percent while foreign investors are down 10 percent when their currency losses are added to their U.S. equity losses!
These rapidly compounding losses are almost certainly going to lead to increased selling of U.S. stocks and dollars by foreign investors seeking to flee the ongoing U.S. financial carnage.
There is also a solid correlation between interest rates after inflation and the dollar.
In the past, when the Fed cut interest rates and yields fell, the rates of return that both American and foreign investors could earn in short-term treasuries fell and the dollar paused. As soon as real rates of return after inflation began to plunge due to active Fed manipulation of short-term interest rates, the U.S. dollar decline accelerated dramatically.
Just as declining equity markets can accelerate the dollar’s slide, so do declining real returns in the U.S. bond markets. Foreign investors are less willing to hold U.S. bonds and finance the U.S. debt if they are going to lose real purchasing power because of inflation. As some of them start to sell and repatriate their capital back into their local currencies, the dollar’s decline will accelerate, leading to even larger losses for the remaining foreign holders of U.S. bonds.
Watching the dollar’s trading and dominant trend is very important for American bond investors and speculators because any widespread foreign selling will hurt the prices of bonds and lead to rising longer-term interest rates, which could start a vicious cycle that affects equities negatively. What does benefit as the dollar falls? Gold.
Gold and the dollar are usually inversely related, since any weakness in the U.S. dollar should cause an increase in the U.S. dollar gold price as long as the international gold price remains relatively constant. This is true because gold is priced in U.S. dollars. Gold prices would, however, remain relatively low if there was physical selling in gold. If the dollar is strong, then one expects imports to be highly priced and exports to remain low. The dollar buys a lot in some countries, while other countries tend to resist importing much of our goods since their currency would be weak relative to ours. Therefore, their currency would buy fewer goods. With a strong dollar goes weakness in gold. Participants are buying the dollar since it has a higher value in other countries. As a result the price of gold falls.
In the reverse case where the dollar is weakening, the U.S. dollar cannot buy much foreign currency, causing exports to rise and imports to fall. As a result, the price of gold rises since it is universally priced and bought if participants fear further weakness in the dollar. Gold is safe and if something happened to the currency of this country, you could use gold in most any other country as currency. If the dollar is weak against other currencies, then gold prices will typically rise. The Dollar Index is therefore an important indicator. Refer back to Figure 4-1.
A piece of the puzzle that also cannot be ignored is the real estate market. In fact, the aggregate market size was at $4.4 trillion by the end of 2000, with institutions owning slightly less than $2 trillion, or 45 percent, of the market. Despite weak economic times in the past, equity investments in commercial and residential property have generally bucked the trend and proved to be important safe havens. Remember, the dollar always seeks a better home, and investors literally like their homes as havens for money when the market is weak. That being said, it is important to recognize that there is a very low correlation between real estate and stock market returns. This is because in bull markets, real estate is also an attractive haven to many. Primarily the belief is because tangible assets that can bring comfort do not correlate well to investment decision making. This allows traders and investors a true method for diversification and even hedge against inflationary times. I am a strong believer and investor of real estate for these reasons. I trade for income and buy real estate for wealth (personal view).
One company that specializes in the flow of low-cost mortgage capital in order to increase the availability and affordability of homeownership for low-, moderate-, and middle-income Americans is Federal National Mortgage Association (Fannie Mae). This company operates under a federal charter, and its primary regulator is the Office of Federal Housing Enterprise Oversight (OFHEO). Fannie Mae is a source of funds for mortgage lenders and investors, providing resources for customers to make additional mortgage loans or investments in mortgage-related securities. The company provides liquidity to the mortgage market for the benefit of borrowers, but it does not lend money directly to consumers. Fannie Mae operates exclusively in the secondary mortgage market by purchasing mortgages and mortgage-related securities from primary market institutions, such as commercial banks, savings and loan associations, mortgage companies, securities dealers, and other investors.
Another company that can shed light on the real estate market is the Federal Home Loan Mortgage Corporation (Freddie Mac), a stock-holder-owned corporation chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing. Freddie Mac purchases single-family and multi-family residential mortgages and mortgage-related securities, which it finances primarily by issuing mortgage pass-through securities and debt instruments in the capital markets.
The importance in following real estate is necessary because the average family has a mortgage and a significant amount of money spent on durable goods to decorate the house; therefore, a substantial amount of wealth is directly correlated to one’s home. By watching a few economic numbers released each month, a trader can get an idea of the relative strength or weakness within the housing market.
Building permits, housing starts, and manufacturers’ new orders for durable goods are all important economic numbers released every month that shine new light on the housing market. It is important to understand that all of these indicators are leading indicators, instead of lagging or being coincidences with the economy.
If the housing market falls, Fannie Mae and Freddie Mac start to witness a significant drop in lending. This drop in household wealth will get traders more nervous about the health of the economy and begin to contract spending outside of the home. The correlation with the market may not be direct; however, the housing market is still a solid barometer of consumer sentiment. Sentiment is important, and the following discussion on gauging fear helps pull sector analysis together.
Created in 1993 by The Chicago Board of Options Exchange (CBOE), the Fear Index (VIX) measures and anticipates market volatility for approximately the next 30 calendar days using stock index option prices. By taking a weighted average of options with a constant maturity of 30 days, the VIX offers the best measure of near-term volatility. Unlike the indices noted above, this index measures volatility. Volatility is the relative rate at which a security moves higher and lower in price relative to volume. If the price of a stock moves up and down rapidly in a short period of time, the stock has a high volatility. On the other hand, if the stock’s price is stable over time, it has a low volatility. If there is high volatility on one stock, many times there is company-specific news to blame and increased volatility as investors try to anticipate how the news will affect the company in the future. The value of this index is that it only measures volatility over a large number of stocks, which better defines underlying sentiment (fear and excitement) in the broad market.
The VIX was aptly nicknamed the “fear index” because it has generally peaked during times of turmoil and fear seen via weakness in equities. Therefore, as VIX rallies (measuring growing fear), investors benefit by selling shares or even shorting the market. Conversely, as volatility subsides and fear diminishes, investor confidence restores and the broad market rallies. This makes the Fear Index a contrarian’s indicator. Just like an oscillator, when the Fear Index gets too low or too high, we can also expect a reversal in the capital markets. These extended levels of fear (peak VIX) and complacency (low VIX) also signal entry methods for reversals. Overextended highs signal buys and over extended lows signal sells. Refer to Figure 4-2 to see the correlation. Finally, volatility can also be used to measure an impending change in trend. As George Soros once said, “Short-term volatility is greatest at turning points and diminishes as the trend becomes established.”
FIGURE 4 - 2 The inverse relationship indicates that traders should buy the market on declining VIX and sell the market on rising VIX. At extended levels, VIX can also act as an oscillator and forecast reversals.
The VIX Index is the CBOE’s near-term expected volatility index for stock index options for the S&P 500 Index. Historically, VIX measured the OEX options (options on the S&P 100 stocks) volatility, but recently the methodology has been updated to now measure the entire S&P 500 (SPX). Options will be covered in a later section but for now know that one of the factors that options derive their price from is volatility. Refer to Figure 4-3 to see how VIX marked many periods of extreme fear.
FIGURE 4 - 3 Notice the large peak in volatility that occurred in the stock market crash of 1987. In October 1987 the Dow fell 508 points (22 percent) and fear was at a maximum.
The CBOE has another volatility index that takes into account the volatility of the Nasdaq 100 options prices. This index is the VXN and is more heavily weighted to the technology side, so it is less reflective of the overall market sentiment. However, it is useful when trading with the technology sector. As with any other indicator, the volatility indices should not be the sole factor in making investment and active trading decisions. The VIX and the VXN are useful when looking at the larger picture and confirming the trading ideas that you are developing.
When monitoring indices, groups of securities selected and tracked together give an overall impression of the movement of a particular group or sector. There are a vast number of indices that make up these capital markets, acting as points of reference or benchmarks by which other securities and sectors can be judged. By comparing individual securities to the benchmark index (S&P 500), the security can be identified as strong or weak. This comparison is called relative strength and is important to the top-down approach.
The importance of comparing these sectors relates directly to money flow. Money flow is a representation of institutional attention. When institutions are attracted to certain sectors such as semiconductors or biotechnology, money will flow into the sector and bell-weather stocks (components) that make up the sector. Therefore, our objective is to measure the market’s appetite for any given sector and then relate that sector’s strength to the overall market indices (S&P 500, Dow Jones Industrials, Nasdaq). Once the sectors that are driving the trend can be determined, we can then analyze the stocks that lead those sectors. This is directly opposite of how most mutual funds do their research, which is bottom up. Bottom-up investing involves choosing specific securities within a particular sector under the guise that good security selection buffers any market level disturbances. As we know, good companies still get punished in bear markets just as mediocre companies can do well in bull markets. While this may not make fundamental sense, perception is reality and perception drives markets. The bottom-up analyst often misses this point.
Bottom-up investing is purely fundamental. Fund managers and research analysts study companies at the grassroots level, such as visiting the factories; testing the goods, products, and services they provide; meeting with management; etc. This approach is very prone to manipulation and subjective opinion. Obviously management of these companies wants mutual funds and other investors to buy their stock, so they are naturally biased to be overly optimistic or perhaps hide difficulties the company may be having. The bottom-up approach can be a real poker game. It is for this reason, among others, that the technician continues to endorse and follow a top-down approach, allowing the data of foundational variables to do the talking rather than biased human interest. Price, time, volume, velocity, and the charts that represent this data cannot lie—but people can. Price accounts for all good and bad news in the market, and the market is always right!
From a broad perspective on trading, it’s helpful to have a feel for the major forces that affect the entire market. If it is clear that economic forces are positive, then you should have a bullish bias in your trading, meaning you should trade more long opportunities than short situations. Use the enthusiasm of the market to improve your odds. If the forces are negative, you should trade with bearish bias and favor shorts to play. Economic forces will have a more pronounced effect on longer-term trades and less impact on momentum trades. An economy that is either entering a contraction period or coming out of one will lend a bias to the market, but what is even more relevant to traders and investors are the announcements of changes in policy and the anticipation of announcements. Chapters 2, 3, and 4 presented a broad overview of the economic forces and institutions that influence the economy and market. To further our interest and help to see the “statistical edge,” we must now begin to put our knowledge to work by viewing specific sectors and stocks through some of the tools provided by the market. Chapter 5 begins this process and lays the groundwork for Part II of the book, “Pictures of Perception.” These pictures will follow the same logic as the business cycle itself, only on a more micro level. Think of each sector and stock we study as micro-economies unto themselves. The confluence of applying macroeconomic events and their impact on the business cycle will directly apply to the same patterns seen on individual stocks (cycles). The alignment of patterns will lead to decisions that increase odds while reducing risk. The collective value of this approach is undeniable.