Instead of looking at financial markets or asset classes on an individual basis, it looks at several strongly correlated markets or asset classes--most often, stocks, bonds, commodities, and currencies. Although once viewed with skepticism, intermarket analysis has now become an accepted part of technical market analysis. Trading with Intermarket Analysis will show you that it has also become an increasingly indispensable part of it. Drawing on his vast experience as both an educator and an expert trader, John Murphy explains what he calls the "new normal" in intermarket relationships that exists as we enter the second decade of the new century. Through a combination of sound economic principles and striking color graphic illustrations, he reveals what those "new normal" relationships are and how you can take advantage of them. In addition, Murphy shows how intermarket analysis plays an important role in asset allocation and sector rotation strategies, both of which are tied to the business cycle, and details how exchange-traded funds ETFs have greatly facilitated the application of intermarket strategies.
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Intermarket Analysis What is Intermarket Analysis? Intermarket analysis is a branch of technical analysis that examines the correlations between four major asset classes: stocks, bonds, commodities and currencies. In his classic book Trading with Intermarket Analysis, John Murphy notes that chartists can use these relationships to identify the stage of the business cycle and improve their forecasting abilities.
There are clear relationships between stocks and bonds, bonds and commodities, and commodities and the Dollar. Knowing these relationships can help chartists determine the stage of the investing cycle, select the best sectors and avoid the worst-performing sectors. Inflationary Relationships The intermarket relationships depend on the forces of inflation or deflation. This means they both move in the same direction. The world was in an inflationary environment from the s to the late s.
These are the key intermarket relationships in an inflationary environment: Positive relationship between bonds and stocks Bonds changing direction ahead of stocks typically Inverse relationship between bonds and commodities Inverse relationship between the US Dollar and commodities POSITIVE: When one goes up, the other goes up also. In an inflationary environment, stocks react positively to falling interest rates rising bond prices.
Low interest rates stimulate economic activity and boost corporate profits. It simply means that the inflationary forces are stronger than the deflationary forces. Deflationary Relationships Murphy notes that the world shifted from an inflationary environment to a deflationary environment around The subsequent threat of global deflation pushed money out of stocks and into bonds.
Stocks fell sharply, Treasury bonds rose sharply and US interest rates declined. This marked a decoupling between stocks and bonds that would last for many years. Big deflationary events continued as the Nasdaq bubble burst in , the housing bubble burst in and the financial crisis hit in The intermarket relationships during a deflationary environment are largely the same except for one. Stocks and bonds are inversely correlated during a deflationary environment. This means stocks rise when bonds fall and vice versa.
By extension, this also means that stocks have a positive relationship with interest rates. Yes, stocks and interest rates rise together. Obviously, deflationary forces change the whole dynamic. Deflation is negative for stocks and commodities but positive for bonds. A rise in bond prices and drop in interest rates increases the deflationary threat, putting downward pressure on stocks. Conversely, a decline in bond prices and rise in interest rates decreases the deflationary threat, which is positive for stocks.
The list below summarizes the key intermarket relationships during a deflationary environment. Inverse relationship between bonds and stocks Inverse relationship between commodities and bonds Positive relationship between stocks and commodities Inverse relationship between the US Dollar and commodities Dollar and Commodities While the Dollar and currency markets are part of intermarket analysis, the Dollar is a bit of a wild card. As far as stocks are concerned, a weak Dollar is not bearish unless accompanied by a serious advance in commodity prices.
Obviously, a big advance in commodities would be bearish for bonds. By extension, a weak Dollar is also generally bearish for bonds. A weak Dollar acts an economic stimulus by making US exports more competitive. This benefits large multinational stocks that derive a large portion of their sales overseas. What are the effects of a rising Dollar? Countries with strong economies and strong balance sheets have stronger currencies.
Countries with weak economies and big debt burdens are subject to weaker currencies. A rising Dollar puts downward pressure on commodity prices because many commodities are priced in Dollars, such as oil.
Bonds benefit from a decline in commodity prices because this reduces inflationary pressures. Stocks can also benefit from a decline in commodity prices because this reduces the costs for raw materials. Industrial Metals and Bonds Not all commodities are created equal. Oil, in particular, is prone to supply shocks. Unrest in oil-producing countries or regions usually causes oil prices to surge. A price rise due to a supply shock is negative for stocks, but a price rise due to rising demand can be positive for stocks.
This is also true for industrial metals, which are less susceptible to these supply shocks. As a result, chartists can watch industrial metal prices for clues on the economy and the stock market.
Rising prices reflect increasing demand and a healthy economy; falling prices reflect decreasing demand and a weak economy. Industrial metals and bonds rise for different reasons. The ratio of industrial metal prices to bond prices will rise when economic strength and inflation are prevalent; conversely, the ratio will decline when economic weakness and deflation are dominant.
Conclusions Intermarket analysis is a valuable tool for long-term or medium-term analysis. While these intermarket relationships generally work over longer periods of time, they are subject to draw-downs or periods when the relationships do not work.
Big events, such as the US financial crisis, can throw certain relationships out of whack for a few months. Furthermore, the techniques shown in this article should be used in conjunction with other technical analysis techniques. One indicator or one relationship should not be used on its own to make a sweeping assessment of market conditions. The slider at the bottom of the chart makes it easy to travel back in time and view the relationship changes as they happen.
Click here for a live Intermarket PerfChart. Additional Resources.
John Murphy (technical analyst)