How to Measure Trends

- Ken Norquay, CMT?EUR?

Is there an economic indicator that can help the average investor sort out the long-term ups and downs of the financial markets?

?EUR?In my book, Beyond the Bull, I encourage people to use their wits to win by providing them with stock market investing strategies. One chapter, "The Countercyclical Model," outlines what we should look for when the stock market is about to change direction. Based on this model, 2013 was an important year.

?EUR?The model makes use of the lead-lag relationship between interest rates, the stock market and the economic cycle.

First-year university economics students learn that the stock market is a leading economic indicator. They are taught that the market peaks before the economy peaks and bottoms before the economy bottoms.

?EUR?The rule of thumb is that the stock market reverses approximately six months ahead of the economic reversal. In other words, by studying the stock market we can make economic forecasts.Unfortunately for equity investors, the opposite is not true: studying the economy will not help you make stock market forecasts. What equity investors need is a lead indicator.?EUR?Fortunately there is one, and here's how it works.

?EUR?Normal economic cycles have periods of expansion and contraction. When the expansion heats up too much, central banks raise interest rates in an attempt to cool down the economy and prevent inflation.If the economy cools off too much, the banks lower interest rates to try to stimulate the economy and prevent a recession or depression.

?EUR?One way of measuring interest rates is the trend of the bond market. When bond prices rise, interest rates are falling. So the 20-year bond market becomes a measure of 20-year interest rates. The five-year bond market is a measure of five-year interest rates.?EUR?However, central banks use short-term interest rates to heat up or cool off the economy, not 20 year or five-year rates.?EUR?Fortunately for stock market investors, long-term interest rates lead short term rates

Fortunately for stock market investors, long-term interest rates lead short term rates. 20- and five-year interest rates reverse before short-term interest rates.

?EUR?Observing the economic cycles of the 20th century, we see that long-term bond market trends lead stock market trends.?EUR?When long-term bonds reverse from up to down, sooner or later the stock market will reverse from up to down. (The same cause-and-effect occurs when long-term bond prices reverse from down to up.)?EUR?Unfortunately for us, this correlation is not 100 per cent accurate. There are times when the bond market and the stock market move in tandem rather than in a lead-lag relationship.?EUR?Although a stock market top could come out of the blue (like the 2007-2008 top), more often the bond market will reverse from up to down before a top in the stock market.?EUR?That's what happened in 2012-2013: long term bond prices corrected, and up turned to down. The Canadian and U.S. long-term bond markets have been declining since July 2012. During that same time, the U.S. stock market has been going straight up.Warning signs?EUR?This divergence is the warning we've been looking for. The economic news from the U.S. has supported what we see in the chart of the bond market, with the Federal Reserve Board talking about decreasing their stimulus for the U.S. economy.?EUR?Higher interest rates and less economic stimulus will leave a weak U.S. economy in danger of crumbling.?EUR?If this realization comes to pervade the thinking of U.S. portfolio managers, they will begin to decrease their exposure to the stock market. That's when the stock market trend will reverse from up to down. The yellow caution flag is up for U.S. stock market investors.?EUR?It's similar in Canada, but the economic emphasis is different. In Canada, the all-time high for the stock market occurred in 2008. A secondary high occurred in spring 2011, about five per cent below the 2008 high.?EUR?The Canadian stock market has been more in tune with commodities prices then with interest rates.?EUR?The current (and weak) six-month rally in the TSX Composite has been powered by financial stocks and consumer goods stocks. Resource stocks, meanwhile, have lagged behind and caused the TSX to languish about six per cent below its March 2011 high.Although Canadian bonds peaked and declined at the same time as U.S. bonds, they have certainly not been a lead indicator of the TSX.?EUR?Every Canadian investor knows that weakness in American stocks means weakness in Canadian stocks. I continue to recommend that Canadian investors allocate significantly lower-than-usual amounts to the equities portion of their overall portfolios.?EUR?American investors, on the other hand, may continue to enjoy the ride: the U.S. stock market has not stopped going up yet. But the yellow caution flag is definitely showing.?EUR?This is not a time for Johnny-come-lately investors to be jumping on board the fast-moving U.S. stock market. This market is for traders only.?EUR?BondsA look at the bond market tells us that American long-term bonds have dropped approximately 21 per cent since the high in July 2012; Canadian bonds have dropped about 11 per cent.Does this mean that bonds are now a bargain, and that we should incorporate more of them in our investment strategies? Or does it mean that the 1980 to 2013 bond market uptrend is over and we should sell?When we make this judgment, we are really making a decision about the long-term health of the Canadian and U.S. economic outlook.Are our economic worries behind us? If they are over, then moderate inflation can return and interest rates can stabilize at current levels or higher.On the other hand, if problems remain, further stimulus and lower interest rates lie ahead and the 33-year bull market in bonds will continue.Here are the 21st century's economic problems, so far:?EUR?* The U.S. real estate and mortgage crash.?EUR?* The collapse of North American manufacturing: now we import from China.?EUR?* The shaky world banking system.?EUR?* The historically high level of consumer debt.If you think these long-term problems have been solved, then you can make a good case for higher interest rates in the future. Long term investing in bonds would therefore be a poor investment.?EUR?But if you think these problems still exist, then you will see the need for even more economic stimulation in the future. Bonds would be a great low risk investment right now.?EUR?GoldWhat about gold as a long term investment? Since its high of US$1915 in August 2011, the price of gold has declined around 30 per cent. Is it a bargain now, or has the 1999 to 2011 uptrend ended? Should we buy more gold, or sell what we have?Unlike bonds, the price of gold does not so much reflect the state of the economy as it does the state of investor psychology. (Gold is often seen as an investor's safe haven for unstable times.)I remember the 1980 high in gold and silver prices. People were lined up in the streets to buy precious metals certificates. It was like Black Friday for investors.I expect the next high in the precious metals market will also be accompanied by manic buying like that. But because that mania was missing at the 2011 high, the long-term uptrend of gold and silver is still in place.?EUR?This 30 per cent correction in the price of gold has resulted in a good time to buy.?EUR?StocksTurning to stocks, here are two current recommendations, (one goldstock and the other oil and gas) for investors that can accept risk. Both have above-average yields.?EUR?Value investors with a taste for volatile stocks should consider Iamgold Corporation (TSX-IMG, $4.26).Since its 2011 top, IMG has fallen from above $20 to below $5 a share. Its dividend yields roughly six per cent. (Compare that with Royal Bank's 3.8 per cent dividend yield.)IMG's insiders have been consistently buying the stock during 2013, and if the long-term uptrend of gold continues, IMG could rise significantly in price.Meanwhile, income-oriented investors who can handle some volatility might consider Canadian Oil Sands Ltd. (TSX-COS, $20.09).The stock has dropped from its 2008 high of over $50 (and its 2011 high of over $30) to its current level near $20.00. At this price, the dividend yield is 7.02 per cent. COS investors will win if oil prices only drop a bit, stay the same, or go up.