Intermarket Analysis:
Introduction
Intermarket analysis examines the way the world markets relate to each other.
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To have inter-relations, you need aunts and uncles. To deal quantitatively with them, you need a formula. You have to contend with their interactions.
So too with inter-markets, which are nothing if not complex and interactive. Here we examine the work of John Murphy. Then, in a follow up, we see what Murray A. Ruggiero adds.
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In his book Intermarket Technical Analysis, John Murphy defines connections among the markets of stocks, bonds, commodities, and currencies. Here's what he says in the preface:
The simple observation that commodity prices and bond yields trend in the same direction provided the initial insight that there was a lot more information to be got from our price charts, and that
insight opened the door to my intermarket journey.Murphy points out that a collapse in the bond market in the spring of 1987 coincided with the explosion in commodity prices and set the stage for the stock market crash in the fall of that year. This led to his more general opinion about interactive processes in the markets:
The interplay between the dollar, the commodity markets, bonds, and stocks during 1987 convinced me that intermarket analysis represented a critically important dimension to technical work that could no longer be ignored.
The premises upon which Murphy bases his work are:
Market interrelationships present an example of the
interactive nature of all behavioral environments.The work has a different focus from looking at specific markets and represents a different emphasis and direction.
The data contrasts with that used to analyze individual markets technically, where indicators like price, volume, and open interest are provided by the market itself.
Technical analysis has the advantage that it can be applied to any reasonably liquid market, particularly where chart data is available. It has a standard basis for comparing markets and doesn't require specialized knowledge in each area, as does fundamental analysis.
The reason is that price data is available throughout the various futures markets.
The relation between commodity prices and Treasury bond prices is the most important of all the relationships, according to Murphy.
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The importance of the relation between commodities and bonds is that it's "the fulcrum on which the other relationships are built." A strong link between them also establishes a link between the commodity markets and the stock market, inasmuch as:
[Stocks are] influenced to a large extent by bond prices. Bond prices and stock prices are both influenced by the dollar. However the dollar's impact on bonds and stocks comes through the commodity sector. Movements in the dollar influence commodity prices. Commodity prices influence bonds, which then influence stocks. The key relationship that binds all four sectors together is the link between bonds and commodities.
The Role of Inflation
Commodity prices are very important, according to Murphy, because they are a leading indicator of inflation, the idea being that rising commodity prices are inflationary, while falling commodity prices are non-inflationary, if not deflationary. Accordingly, commodity prices tend in the opposite direction to Treasury bond prices and therefore in the same direction as Treasury bond yields.
The economic explanation is that commodity prices increase with demand and/or shortages in supply. These changes occur during periods of economic expansion, which consumes more commodities. So too does the increase in the demand for money, needed to fuel the expansion.
To combat inflation, the Fed raises (short-term) interest rates, by decreasing the liquidity in the system -- i.e. the money supply. Tightening the supply tends to throttle borrowing and leads to an economic slowdown and recession. Demand for raw materials and money then decreases, and this leads back to lower commodity prices and a drop in interest rates.
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When the cost of money decreases, the cost of doing business tends to decrease also. This increases the potential for improved earnings and heightens demand for stocks, tending to raise their value. Interest varies inversely to bond price, so there is a strong positive correlation between bonds and stocks. They tend to move together, just as short-term and long-term money instruments (bills, notes, and bonds) are correlated.
Lead Time
The bond market is more sensitive to monetary demand than the stock market -- it reacts more quickly to monetary changes. So it's to be expected that the bond market will turn down before the stock market when demand for money passes its maximum and begins to turn down.
Tops in bonds are usually associated with an increase in commodity prices, a precursor to increased cost in doing business, and a reduction of profits. In effect, the bond market becomes a leading indicator, and a downturn in (bond) prices signals higher money costs and the beginning of the end for the stock market. The lead time can be several months. This was the case in 1987, since the bond market topped out in the spring and the stock market didn't top out until the fall, approximately four months later. In other words, there was a negative divergence of prices throughout the summer.
In a similar way, bonds lead stocks to the upside. In October of 1987, for example, while the stocks came crashing down, bonds began to turn up as money was transferred to them in a so-called investor flight to quality. During the market panic, the Federal Reserve poured money into the financial system to cushion the market fall. This increase in liquidity pushed short-term interest rates lower, which sent bond prices higher. And again we had a period of divergence between stocks and bonds, in contrast to the normal positive correlation between them. (See chart examples.)
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Similar divergences occur between short- and long-term debt instruments. Treasury bills, for instance, tend to fall more quickly than bonds when liquidity dries up because of Fed tightening to cool off an overheated economy and control inflation. Short-term rates can then rise above long-term rates. Known as an inverted yield curve, this condition signals the end of economic expansion and is a precursor of a drop in the stock market.
The Futures Markets
The futures market is a more sensitive measure of monetary actions. As Murphy explains:
In general, when T-bill futures are rising faster than bond futures, a period of monetary ease is in place, which is considered supportive of stocks. When T-bill futures are dropping faster than bond prices, a period of tightness is being pursued, which is potentially bearish for stocks. Another weapon used by the Federal Reserve Board to tighten monetary policy is to raise the discount rate.
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It is said that a rising dollar is good for bonds and stocks and a falling dollar is bearish for bonds and stocks. But the relationship is more complicated in that its effect is normally felt through inflation, and this, again, relates to commodities.
Turns in the dollar eventually impact bonds, but only after long lead times, and the impact on stocks is even more delayed. It takes time for the inflationary effects to filter through the system. Commodity prices are a leading indicator of inflation, and since they represent the prices of raw materials, this is where the impact of the dollar is first felt. The effects begin to show up when the commodity markets start to move higher. That's when the falling dollar becomes bearish -- when the added costs reduce profits. "Conversely, a rising dollar becomes bullish for bonds and stocks when commodity prices start to drop." (See charts.)
It gets more complicated in a deflationary trend. Cash and very secure debt instruments tend to rise in value (or at least hold their value) because of demand, but stocks, lower quality bonds, and commodities of all kinds tend to lose value In bad times there is a rush to higher quality instruments.
The Role of Gold
As one of the commodities in the CRB, gold has an important part to play in the relationship. First, it is sensitive to dollar trends, so it tends to lead turns in the CRB index. "A trend change in the dollar will produce a trend change in gold, in the opposite direction, almost immediately." Eventually, the trend change in the gold market will spill over into the CRB.
The Bull/Bear Cycle
The value of the dollar is determined in part by the interest it earns -- compared to other currencies. The more it earns, the more attractive it is. This exerts an upward pull on it. It pushes gold lower almost immediately and eventually also pushes the other commodities lower. (The dollar buys more.) But interest rates tend to follow commodities lower, so bond prices tend to go higher. The stock market follows and goes higher, as well. The bull phase.
But lower interest rates now begin to go against the dollar
, making it less attractive and pushing it lower. This effect eventually pulls commodity prices higher again. When commodities go higher, bond prices go lower, eventually bringing stock prices lower, too. The bear phase.
Lead Times
The dollar is more sensitive to short-term interest rates (T-bills) than to long-term rates. On the other hand, long-term rates (bonds) are more sensitive to longer range inflationary expectations. Murphy's research shows that the lead time between turns in gold (or the dollar) and the CRB index can be as much as a year for major turns, and that it will lead by about four months at short-term and intermediate-turn changes.
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Stocks, bonds, commodities, and currencies are not only affected by domestic conditions, but also by developments in foreign countries. We are now in a global economy. Interactions can, and do, occur on a global level as well as the domestic level. Interest rates and inflation are global phenomena.
As Murphy shows in his charts, global markets tend to move in the same direction, but don't necessarily make their turns at the same time. Divergences can occur. These divergences can provide useful information regarding the direction of individual issues.
The stock markets of individual countries may not rise or fall by the same amount or at precisely the same time, but are nonetheless influenced by the global trend. (See Prechter for a good treatment of the subject.) You should be aware of, and pay heed to the global trends before making a commitment to particular stocks. In fact, you might get a tip on what to do by noting divergences in the global environment. Some foreign markets tend to top out earlier than later, and their action can signal turns in the other markets. For example, the UK market often tops out ahead of the US markets. (See Murphy for the chart data.)
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