This case study examines the downturn in U.S. equity markets coinciding with the Financial Crisis of 2007-2008 from the perspective of an analyst/trader that utilizes fundamental, technical, quantitative, and intermarket analyses. While sentiment indicators show a bearish contrarian signal and momentum indicators reveal overbought conditions, altogether providing strong confirmation, basic charting analysis tells the story of the bearish turn in U.S. equity markets in 2007, simply and clearly. A long-term and intermediate-term view of intermarket relationships between bond yields, stock prices, and commodity prices leading up to the downturn complements the analysis.
Bond Yields, Stock Prices, Commodity Prices
Intermarket analysis indicates deflationary conditions dominate the U.S. economy in the 21st millennium. Following the burst of the Dot-com Bubble in 2000, U.S. equities sell-off, finally bottoming in 2002-2003 (first arrow in Chart 1); this precedes the trough in bond yields by several months(second arrow in Chart1). Interestingly, commodity prices rebound ahead of equities by about 12 months. The close positive link between equities and commodities and their positive correlation with bond yields signal deflation. Under disinflation and inflation, bond yields tend to show negative correlation (or, bond prices have a positive correlation) to equities.
An uptrendline drawn below a series of lows of the UST 10-year yield commencing from early-2003, ignoring the down spike in mid-2003, acts as a barometer for the financial markets (uptrendline in Chart 1). Each time yield touches the trendline and bounces upwards reinforces the bull trend in equities and commodities. Finally, in late-October 2007, the UST 10-year yield penetrates the uptrendline at the exact time the S&P 500 touches its swing high (ellipses in Chart 1): The U.S. Bear Market of 2007-2009 starts.
Note that yields complete a double-top in mid-June 2007 (long horizontal black line in Chart 2) that a fixed income trader may use to go long bonds. When, on August 9, BNP Paribas terminates withdrawals on three hedge funds due to liquidity concerns, the fixed income trader has his/her confirmation…seven to eight weeks ahead of the aforementioned yield-uptrendline penetration.
Astute equity traders would tighten trailing stops (losses), at the minimum, or, better yet, exit long positions immediately, recognizing from sentiment indicators that “everybody” is long equities (and short bonds), and the exit door would, therefore, be narrow. Aggressive traders would execute a stop-and-reverse (SAR) trade. Novice and slow-to-react traders would wait for penetration of the head-and-shoulders neck line in the S&P 500, which came in mid-January 2008 (ellipse in Chart 3).
Intermarket analysis represents a useful tool for gauging asset class relationships. Changes in these relationships can provide an early-warning to changes in trends in equity, bond, commodity, and currency markets. Lastly, sometimes, basic charting analysis can reveal the story and associated trading opportunities, simply and clearly.