The Intermarket Analysis is an appendix of technical analysis, which received significant success based on publications of John Murphy at the beginning of the 1990s.
The focus of this form of analysis is the examination of relations between the various classes of assets.
Market operators can use the combination of signals in bonds-commodities-equity markets to recognize which part of the economic cycle is the market is in and what categories of assets should be over or underweighted.
In particular, the Intermarket Analysis helps to achieve a better global understanding of the financial markets. Our cover story shows how do the principle of Intermarket Analysis and these traditional links have changed over the years.
Classic Intermarket Relations
While economists analyze statistics more to define the direction of the economy and consequently of the financial markets, technical analysts examine the markets themselves.
Economists identify trends and patterns and deduce the forecasts for the future. The Intermarket Analysis makes a further step forward and pursues the following principles:
All markets (shares, bonds, commodities, forex) are related.
No market moves in isolation from another.
The analysis of a market must involve all the other analyses; an analyst using an Intermarket approach looks beyond his own nose and combines technical analysis with the economic cycle.
Below we see a simple statement of the four most important reports Inter-market Approach Analyst John Murphy introduced in 1990:
- A positive correlation between bond and equity prices.
- An inverse correlation between the prices of commodities and of bonds.
- A positive correlation between equities and commodities.
- An inverse correlation between the US dollar and commodities.
The economic cycle
It is fairly well known that economic development has cyclic progress (known as The Economic Cycle) that can be divided into individual steps.
These phases of expansion and contraction form economic cycles, contributing to explain the correlation between the markets of equities, bonds, and commodities. At the same time the economic cycle is the basis for the progression of maxima and minima on these markets.
The Six Stages
Stage 1: Contraction in economic activity, the curve of interest rates flat. The expansionary monetary policy (reduction in the basic rate) causes an increase in the prices of bonds
Stage 2: Further reductions of the base rates. Economic activity reaches the lowest point and stabilizes. The stock market expects this development and climbs months before the official end of the recession.
Stage 3: A substantial improvement in the economic context. Approaching the expansion phase. A steep curve of interest rates. Equities are already increased considerably and the commodities are following them.
Stage 4: The economic expansion and interest rates are at their highest points. The actions and the commodities have a bullish tendency, the bond market decreases because of the danger of inflation.
Stage 5: Peak of economic growth, further increases in rates basis. The economy is still growing but is slower than before because of the interest rates on the increase and an increase in commodity prices. The stock market expects the contraction phase in arrival and reaches its maximum before the end of the expansion step. Only the commodities market is still strong – with a maximum that needs more time to be achieved.
Stage 6: Economic development becomes worse, the economic cycle is preparing for the transition from the phase of expansion to that of contraction. The yield curve turns.
All three categories of securities have a bearish trend.
We repeat that this is an ideal path in the course of a normal situation – which means inflationary. In a deflationary scenario, price trends for each category of securities act in the opposite direction.
Stocks, Bonds, and Commodities
We well know the economic relationship between the three major markets is that the commodity prices will affect prices of bonds through the increase of inflationary pressure and those affect prices of actions.
But what is the chronological order of maxima and minima of the different markets?
The bond market reverses – it is statistically proven – before the stock market and the markets of the commodity and plays an important role in the analysis Intermarket.
Bonds usually reach their maximum in the middle of an expansion phase and build the minimums in a phase of contraction.
Then, if there is an inversion of the bond market during a phase of economic growth this means that the growth of the phase of the “healthy”, non-inflationary, is finished, and the growth of phase “unhealthy”, inflationary, begins.
In this moment the markets for commodities speed up their bullish trend and are approaching the end of the expansion phase.
Exception: With deflation, the combination of commodities and weak bonds can be a positive signal for the phase, because it shows that the forces deflationary are weakening.
Rotation of the sectors
The economic cycle has a significant influence on relations between shares, bonds, and commodities.
It plays an important role in making the industry’s choice sectors more attractive because each step favors one or the other industrial sector.
The knowledge of the current phase of the economic cycle is an important indicator to help to decide which industry to choose.
At the end of a phase of economic expansion, the energy stocks assume a leading role.
This is mainly because of rising energy prices signal inflations that alerts central banks.
Subsequent increases in interest rates weaken economic development and result in a reduction in growth or even can cause a recession.
When the cycle passes to promote, energy stocks, the sectors most defensive, as consumer goods, the investor of equities should be cautious. Here, in fact, we can expect to see a reversal of the stock market and a contraction of the economy.
Warning Ratio for the stock market
The maxima (market top) and minima (market bottom) in the stock market, in bond and in commodity often occur in a predictable order (depending on the economic situation).
Only the foreign exchange markets play a minor role. Therefore, the influence of the U.S. dollar is often filtered through its influence on the markets of the commodity.
These two markets show an inverse relationship, so it usually combines an increase of the US dollar with a decrease in the price of raw materials, and vice versa.
This is true for precious metals, as these have shown in the long term to be a haven in periods of equity markets weak.
Returning to the initial question: How can I use different markets for different asset classes to analyze the stock (equities) market?
It is recommended to analyze the metals sensitive to the economic cycle, such as copper or the full complement of precious metals, to get a direct view of the situation of supply and demand in the market for commodities (and also to take into account that some raw materials depend heavily on political factors or climatic conditions).
An effective way to analyze the sustainability of the stock market, in combination with the bond markets and commodity is the ratio of precious metals-bond.
If the commodity increases, bond prices fall and hold their relationship.
This conformation is bullish for the stock market – on the contrary, a decreasing ratio predicts a weak economy and consequently a stock market weakness.
The historical examples
We can use the example of the collapse of 1987 to show that it is not enough to make an isolated analysis of a single market. The causes of this crash are under discussion.
From the point of view of the Intermarket analysis, there were warning signals on the bond market four months before the crash. But analysts and investors did not recognize them.
Another example is the Gulf War in 1990 – The traditional Intermarket relations have worked throughout the world both at the beginning and at the end of the crisis in the Middle East. If you look at the mega-top of the stock market in 2000, it emerges that the analysis Intermarket was a precious help.
Several months before the crash in equity markets have revealed important alarm signals. In chronological order:
October 1998: Maximum (Market Top) in the bond market
March 2000: Maximum (Market Top) in the stock market
October 2000: Maximum (Market Top) in the commodities market
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External sources: Wikipedia