Point & Go Figure: A Case for Deflation?
Alas poor Inflation, I thought I knew ye.
One of the simplest indicators used to evaluate inflation/deflation is the CRB Index/Bond Ratio. I first encountered this indicator in John Murphy's book, "Intermarket Analysis."
This indicator takes the CRB Index and divides it by the price of the 10-Year Treasury Note. This is what is called a "relative strength" measure. In my opinion, point and figure charts are ideal charts for measuring relative strength since the signals they provide (easily discernible buy and sell signals) allow trends in relative performance to fully develop. Because point and figure charts use "significant" price movement to construct the charts, and because they are not time sensitive, the only thing that can interrupt a trend is an important change. Trends are easy to see, but difficult to follow. That is probably the single greatest reason that trend-following gets such a bad name; trend followers have trouble following their trends.
Point and figure relative strength analysis forces a trend follower to stay within sectors or groups that are outperforming. For a trader, this prevents us from trading ourselves out of a good, long-term position.
Let's look at a 10-year history of the CRB/Bond Ratio to see how this chart can help identify important secular inflation/deflation themes.
A rising CRB/Bond Ratio is generally negative for stocks, since it signals rising inflation and usually higher interest rates. However, it is important to note that during deflationary periods, the normal relationship does not hold true and rising commodity prices can actually be positive for stocks.
As an example of the normalized relationship - rising CRB/Bond Ratio is typically negative for stocks, look at the period between June 3, 1999 and February 26, 2001. I chose these dates because that is when the chart gave actual point and figure buy and sell signals.
From June 3, 1999 to Feb. 26, 2001, the CRB Index was up 14.8% while the S&P 500 was down 2.5%, the Dow was down .2% and the Nasdaq Composite was down 3.9%.
As deflation began to appear more frequently in the headlines in 2001, the deflationary relationship - falling CRB Index concurrent with falling stocks - became manifest. From the time of the point and figure sell signal in the CRB/Bond Ratio on February 26, 2001 until the new buy signal on November 22, 2002, which should have signaled a positive period for stocks (falling CRB/Bond Ratio generally is positive for stocks). During that period the CRB Index (although the ratio itself was falling) was up 5.4% while the S&P 500 was down 26.6%, the Dow was down 17.2% and the Nasdaq Composite was down 36.3%.
Since that buy signal on the CRB/Bond Ratio the chart has given secondary, follow-up buy signals in October 2003, November 2004, and most recently September 28 of this year.
Meanwhile, from November 22, 2002, the date fo the first CRB/Bond Ratio buy signal, the CRB is up 38.7%, the S&P 500 is up 28.9%, the Dow is up 17.9% and the Nasdaq Composite is up 44%.
But wait, I thought a rising CRB/Bond Ratio was typically a negative for stocks? It is, unless we are operating in a deflation. But look at commodities prices! Are you saying we've been in a deflation since 2001? You cannot be serious!
Ok, take a look at this next chart. This is the absolute price chart of the CRB Index.
CRB Index (CR/Y)
So now we have a rising CRB/Bond Ratio even as the CRB Index has violated structural support. The primary stock market indicators are in a negative context. Many stocks are violating important trendlines, especially rate-sensitive stocks in the areas of financials, real estate and utiltiies. These stocks should begin outperforming during a falling CRB/Bond Ratio period. But they are not. At least not yet. This suggests deflation, which I believe never really went away, but simply became muted below rising energy costs, is reasserting itself.
With the CRB Index having violated structural support, the stock market main indicators showing a negative overall context, a new sell signal for the CRB/Bond Ratio would be very interesting. It has not occurred yet, though the level of the chart is off the September highs.
Meanwhile, a longer-term chart of the 10-year yield index is tracing out a potential multi-year head and shoulders top (not coincidentally dating back to August 2003) and the US Dollar Index remains positive in point and figure terms.
10-Year T-Note Yield Index (TNX)
Falling commodities? Falling stocks? Falling 10-year yields? Rising dollar? You tell me what that means, because as far as I can tell, that is a recipe for only one thing - deflation.
All charts courtesy Dorsey, Wright.
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