In the classic American musical fantasy 1939 film, The Wizard of Oz, while walking through the dark forest, Dorothy, the Tin Man, and the Scarecrow hear noises around them. It causes the Scarecrow to repeat over and over the phrase - Lions and tigers and bears. Dorothy adds, Oh My, as they travel through the forest, chanting this line to calm themselves from an impending threat.
Today, the financial markets have also come under attack. Not by the wicked witch of the west, as in the L. Frank Baum's celebrated film, but by geopolitical turmoils in Europe and Asia, Fed's tight monetary policies, inflationary pressures, and macro-economic uncertainties.
Instead of focusing on headline news, it is more effective for investors to closely monitor the relationships between the four asset classes, including Stocks, Bonds, Commodities, and Currencies, to understand the sustainability of the primary trends and potential trend reversals.
There are well-defined historical relationships between Stocks (S&P 500 Index – SPX), Bonds (30-year US Treasury – USB), Commodities (CRB Index – CRB), and Currencies (US Dollar Index – USD).
Understanding these relationships can help investors better manage their financial goals and, most importantly, determine the various stages of an investment/business cycle.
An inflationary environment differs from a hyperinflationary or runaway inflation. Inflationary periods occur when inflationary forces are stronger than deflationary forces. Under this scenario, the relationships between the above four asset classes are as follows:
Stocks and Bonds are positively correlated. They tend to move in the same general direction. Bonds tend to lead stocks in predicting pivotal trend changes.
Bonds and Commodities are inversely correlated. That is, they tend to move in the opposite direction.
US dollars and Commodities are also inversely correlated.
Stocks and Commodities tend to be positively correlated.
A deflationary environment occurs when there are nominal or even no inflationary pressures. The four asset classes will have the same Intermarket relationships as during an inflationary environment except for one relationship - stocks and bonds are inversely correlated, during deflationary periods. Stocks rise when bond prices fall, and vice versa. It translates to stocks and interest rates also rising and falling in unison with one another.
Since investors are focusing on inflation, enclosed are the Intermarket relationships between CRB and SPX, USB, and USD.
Minor divergences or discrepancies from historical relationships alert investors and traders to potential corrective phases of an overall primary trend. However, if these trends persist, it warns of potential peaks/bottoms and impending directional trend changes in the asset classes in question.