Today I want to look at the three major asset classes, bonds ($USB), equities ($SPX), and commodities ($GSG) and how they can help us better understand where we are in the business cycle. John Murphy in his book Trading Intermarket Analysis does a great job at highlighting the relationship between these three asset classes and how they function during the business cycle.
Murphy references the following chart of the business cycle and shows that depending on what stage of the cycle we are in, the assets perform differently. Based on this, and I’ll show the chart further down in the post, it appears we may be entering stage four. I’ll explain why later. Here’s how Murphy describes the cycle, ” The business cycle is shown as a sine wave. The first three stages are part of an economic contraction (weakening, bottoming, strengthening). Stage 3 shows the economy in a contraction phase, but strengthening after a bottom. As the sine wave crosses the center line, the economy moves from contraction to the three phases of economic expansion (strengthening, topping and weakening). ”
Before we look at the current market, lets take a look at previous market peaks (no I’m not calling for a market top, keep reading). As Murphy describes, during a normal cycle we will see bond prices top out first and begin a down trend, followed by stocks with commodities being the last to weaken. This is how things played in 2000. As the chart below shows, the top panel is the 30-year Treasury Bond ($USB) which broke its up trend in late 1998 with equities ($SPX) topping out in 2000, followed by commodities ($GSG) in the bottom in early 2001.
Next up we have the market peak in 2007. Price action played out slightly differently leading up the economic cycle peak. While bond prices put in their low in 2004 we began seeing lower highs and higher llows from 2005 through 2007. Equities followed by peaking in 2007 and commodities ultimately toppled over in 2008.
So how do things look now? Not too bad. All three asset classes are still in their up trends; however, bonds are well off their highs. The 30-year Treasury bond appears to have potentially topped out last year as it starts to threaten its trend line off the 2007 and 2011 lows. Commodities, while not a great performer during the current bull market, are still in an up trend. And of course equities continue to make higher highs and higher lows with plenty of space between price and its trend line.
This is why I think we may be getting close to stage four in the business cycle. It’s possible we see bonds break their up trend in 2014 and light the match for economic contraction and ultimately a peak in equity prices. But it’s important to remember that the time between the peak in bonds and the top in equities can be years. Look back at the first chart, Treasury’s hit their high nearly two years before equities topped out.
While each market period is unique and involves different forces and economic environments, I think it’s important to watch these three assets and how they are related to one another. Based on the above chart it seems we are still in expansion phase of the economy and the market. I’ll be watching how things progress as we kick off 2014 and how these three assets perform.
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