224 COMMODITIES AND ASSET ALLOCATION

portfolio managers becomes more realistic. The high correlation of the CRB index to

inflation gauges qualify commodities as a reliable inflation hedge.

Futures markets—including commodities, currencies, bonds, and stock index

futures—provide a built-in forum for asset allocation. Because their returns are poorly

correlated with bond and stock market returns, professionally managed futures funds

may qualify as a legitimate diversification instrument for portfolio managers. There

Intermarket Analysis

and the Business Cycle

Over the past two centuries, the American economy has gone through repeated boom

and bust cycles. Sometimes these cycles have been dramatic (such as the Great De-

pression of the 1930s and the runaway inflationary spiral of the 1970s). At other

times, their impact has been so muted that their occurrence has gone virtually un-

noticed. Most of these cycles fit somewhere in between those two extremes and have

left a trail of fairly reliable business cycle patterns that have averaged about four

years in length. Approximately every four years the economy experiences a period of

expansion which is followed by an inevitable contraction or slowdown.

The contraction phase often turns into a recession, which is a period of neg-

ative growth in the economy. The recession, or slowdown, inevitably leads to the

next period of expansion. During an unusually long economic expansion (such as

the 8-year period beginning in 1982), when no recession takes place, the economy

usually undergoes a slowdown, which allows the economy to catch its breath before

resuming its next growth phase. Since 1948, the American economy has experienced

eight recessions, the most recent one lasting from July 1981 to November 1982. The

economic expansions averaged 45 months and the contractions, 11 months.

The business cycle has an important bearing on the financial markets. These

periods of expansion and contraction provide an economic framework that helps

explain the linkages that exist between the bond, stock, and the commodity markets.

In addition, the business cycle explains the chronological sequence that develops

among these three financial sectors. A traders interest in the business cycle lies not

in economic forecasting but in obtaining a better understanding as to why these three

financial sectors interact the way they do, when they do.

For example, during the early stages of a new expansion (while a recession or

slowdown is still in progress), bonds will turn up ahead of stocks and commodities.

At the end of an expansion, commodities are usually the last to turn down. A better

understanding of the business cycle sheds light on the intermarket process, and re-

veals that what is seen on the price charts makes sense from an economic perspective.

Although its not the primary intention, intermarket analysis could be used to help

determine where we are in the business cycle.

225

226 INTERMARKET ANALYSIS AND THE BUSINESS CYCLE

Some understanding of the business cycle (together with intermarket analysis of

bonds, stocks, and commodities) impacts on the asset allocation process, which was

discussed in chapter 12. Different phases of the business cycle favor different asset

classes. The beginning of an economic expansion favors financial assets (bonds and

stocks), while the latter part of an expansion favors commodities (or inflation hedges

such as gold and oil stocks). Periods of economic expansion favor stocks, whereas

periods of economic contraction favor bonds.

In this chapter, the business cycle will be used to help explain the chronological

rotation that normally takes place between bonds, stocks and commodities. Although

Ill continue to utilize the CRB Futures Price Index for the commodity portion, the

relative merits of using a couple of more industrial-based commodity averages will be

discussed such as the Spot Raw Industrials Index of the Journal of Commerce Index.

Since copper is one of the most widely followed of the industrial commodities, its

predictive role in the economy and some possible links between copper and the stock

market will be considered. Since many asset allocators use gold as their commodity

proxy, Ill show where the yellow metal fits into the picture. Because the bond market

plays a key role in the business cycle and the the intermarket rotation process, the

bond markets value as a leading indicator of the economy will be considered.