Tips on Technicals - Know Your Indicator
Technicians use many indicators to help them make trading decisions. More often than not, these indicators are limited to a few familiar ones that are applied blindly in all situations. However, some are better at calling market tops while others are better at bottoms. Some work better in trending markets and some better in trading ranges. It is important to know the characteristics of the indicators so that they can be applied in the proper setting.
Old Faithful
One of the most widely used indicators is a relative comparison between the Bridge-CRB Index (Commodities Research Bureau Index of futures prices) and US Treasury Bonds. When commodities prices are rising, inflation fears are ignited and interest rates go up. When rates go up, the bond market goes down. The relationship between the Index and bonds has been exploited for decades by technicians, fundamentalists and economists alike.
Now consider the periods of time when the two markets move in the same direction. Figure 1 shows the Index and December 1997 CBT T-Bonds from May to October 1997 (percent change scale). From May to July, the characteristic inverse relationship between the two is clear. From July to October, the story is very different as the two traded up and down together. How can this happen?
Before we find that answer, let's examine the Bridge-CRB Index a bit more.
Building Blocks
The Index is an unweighted group of 17 major futures contracts traded in the US. Just as in the stock market, commodities can be grouped into sectors. These are energies, softs, grains, livestock, precious metals and industrials. Each can be charted alone or together in a relative strength analysis. The latter is no different from charting a stock in relation to the S&P500 Index to see how it is performing relative to the market as a whole.
Figures 2 and 3 show the two sectors normally associated with inflation, the precious metals and the energies. Both had been rising. The bond market did not seem to be worried about that as it, too, was going up. So what exactly was the bond market looking at in relation to commodities prices?
While the combined agricultural sectors (not shown) were relatively flat, the industrial sector (Figure 4) had been heading lower for months without reprieve. As industrial input prices dropped, output prices were not under any inflationary pressures and interest rates stayed low.
Your Own Conclusions
This chapter is not meant to provide a full analysis of the commodities and bonds relationship. It is intended to show how traditional views of indicators and unchallenged beliefs when using them can have incorrect, and unprofitable, outcomes. Any indicator, if applied rigidly, is subject to failure as the nature of the markets changes. By understanding what the indicator is trying to find and how it goes about its task, we can remain flexible. Keeping an open mind enables us to adapt to the markets rather than trying to the make the markets adapt to us.
