The financial markets comprise more than 500,000 securities, derivatives, currencies, bonds, and other financial instruments. All interact with each other to some extent and a seemingly unimportant event can cause a chain of reactions causing a landslide of large-scale changes to the financial markets.
The rapid progress of global communications has contributed to the integration of all international financial markets as the world has gotten smaller due to the ability to communicate almost instantaneously.
Relationships that were dismissed as irrelevant in the past cannot be ignored anymore as the globalization of the markets contributes to a convergence of formerly unrelated markets
As the name implies, Intermarket analysis is the study of how various financial markets are related. This is a departure from prior forms of market analysis, which relied primarily on a single market approach.
Stock market analysts, for example, used to spend their time analyzing the stock market, which included market sectors as well as individual stocks. Stock traders didn’t have much interest in what was happening in bonds, commodity markets, or the dollar (not to mention overseas markets).
Fixed-income analysts and traders spent their time analyzing the bond market without worrying too much about other markets. Commodity traders had their hands full tracking the direction of those markets and didn’t care much about other asset classes.
Trading in currency markets was limited to futures specialists and interbank traders. The four asset classes involved in Intermarket work are bonds, stocks, commodities, and currencies.
Why traders should use Intermarket analysis?
Understanding helps you appreciate how other financial markets influence whichever market you’re primarily interested in.
For example, it’s crucial to know how bonds and stocks interact. A second reason why it’s important to understand Intermarket relationships is to help with the asset allocation process.
There was a time not too long ago when investors’ choices were limited to bonds, stocks, or cash. Asset allocation models were based on that limited philosophy. Over the last decade, however, investment choices have broadened considerably.
The relationship between Bonds and Stocks
The relationship between bonds and stocks is a very important link in the Intermarket chain. Those two markets continually compete for investor funds. When investors are optimistic about economic trends, they favor stocks. When they’re pessimistic, they favor bonds. Investment portfolios generally include both asset classes, but not always to the same degree. A standard portfolio usually allocates 60 percent to stocks and 40 percent to bonds.
There are times when it makes sense to overweight bonds and other times when it’s better to overweight stocks. In order to do that, however, it’s important to know how to chart the two asset classes and how to compare their relative performances.
It’s also important to understand the economic forces that drive their relative performance. That includes some understanding of actions taken by the Federal Reserve to influence interest rate direction and asset allocation.
Figure 1 shows the correlation between sp500 and US10 Year Yield. The correlation is changing over time as the Federal Reserve influences interest rate direction which affects the stock and bond market.
Investors can use ratio analysis in asset allocation between different assets. Figure 2 shows the ratio between the sp500 and US10 bond prices when the ratio moves in an uptrend means stocks are outperforming the bond market and it is a good time to be overweight in stocks.
The relationship between Bonds and commodities.
Bond and commodity prices normally trend in opposite directions. Treasury bond prices are very sensitive to the threat of inflation. Rising commodity prices are viewed as a leading indicator of inflation. As a result, an inverse relationship usually exists between bond and commodity prices. In other words, bond and commodity prices normally trend in opposite directions. Rising commodity prices normally cause Treasury bond prices to fall. Falling commodity prices normally result in higher bond prices.
The CRB Index was first published by the Commodity Research Bureau in 1958. The Thomson Reuters/Jefferies CRB Index includes 19 commodities, all of which are traded on exchanges in the United States and London. The CRB Index formula includes commodity contracts that lie within six months of the current date.
Figure 3 shows the relationship between the CRB index and US10 bond prices majority of the time both have a negative correlation.
Bond prices are closely tied to the direction of the economy. As a result, a weaker economy produces higher bond prices (and lower bond yields). Conversely, a stronger economy results in weaker bond prices (and stronger bond yields). Of the 19 commodities in the CRB Index, copper is the most closely tied to the economy. As a result, copper is very closely tied to the trend of the bond market.
Investors can use ratio analysis in asset allocation between different assets. Figure 4 shows the ratio between the CRB index and US10 prices when the ratio moves in an uptrend means commodities are outperforming the bond market and it is a good time to be overweight in commodities.
The relationship between Stocks and commodities
The two markets are trending together, and the correlation between the two markets swung between positive and negative. however, the correlation between the two markets is an average positive correlation.
Figure 5 shows the relationship between the CRB index and stock prices majority of the time both have a positive correlation.
Figure 6 shows the ratio between the CRB index and stock prices when the ratio moves in an uptrend means commodities are outperforming the stock market and it is a good time to be overweight in commodities.
The use of Intermarket correlation analysis can help you improve your trading system by avoiding trades against the prevailing direction of correlated markets, but can also be used on its own to develop a complete system based on divergences between two or more highly correlated markets. Knowing the correlation of the market you propose to trade with other markets is very important for predicting its future direction. In addition, short-term traders can take advantage of the time difference between world markets and anticipate the next day’s movement. Asian markets are the first to start trading, followed by European markets. For a US trader, the insight gained from all preceding markets is a valuable tool in predicting at least the opening in his local market.
Intermarket analysis can also be useful in estimating the duration and state of the business cycle by watching the historic relationship between bonds, stocks, and commodities as economic slowing favor bonds over stocks and commodities.
Near the end of an economic expansion bonds usually turn down before stocks and commodities and the reverse is true during an economic expansion. Bonds are usually the first to peak and the first to bottom and can therefore provide ample warning of the start or the end of a recession. Bonds have an impressive record as a leading indicator for the stock market, although this information cannot be used in constructing a trading system as the lead times can be quite long, ranging from one to two years.
Intermarket analysis is all about relationships. All of the charts included are designed to show how closely related all financial markets are and, more importantly, how that information can be used to improve the forecasting process. Intermarket analysis is also an increasingly important part of technical analysis. Correlations between the various financial markets over the past few years have gotten so strong that it’s nearly impossible to understand what’s happening in any one market without knowing what’s also happening in all of the other markets. Fortunately, it’s not that hard to keep track of all those markets.
The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.