Intermarket analysis is a method of analyzing markets by examining the correlations between different asset classes in various financial markets. What happens in one market could, and probably does, affect other markets, so a study of the relationship(s) could prove to be beneficial to the trader when placing trades in the financial markets.
In this Wiki, we will explore subjects on Intermarket Analysis such as the Links between Bonds and Stocks, The Links between Commodities and Bonds, Deflation and its Effects and much more.
Intermarket Analysis
To get a good grip on financial trading we need to take a few minutes out to look at something called "Intermarket Analysis" and how various asset classes and markets relate to each other.
Overview of Intermarket Analysis
In general, equity shares prices of publicly listed companies are highly cyclical. For example, investors and traders typically shift out of shares and into fixed-income securities, such as bonds, when they expect or are fearful of a recession taking place in a particular country. When they expect that the recession is coming to an end and a recovery is near they then move their money back into equity shares and equity markets. This cyclical trading activity between recession and expansion within an economy is a basic cycle of preserving capital and seeking to gain high yields.
The idea of moving into and out of asset classes when the fear of recession and greed for economic expansion is also known as "Risk Off" and "Risk On". Risk on and risk off is what all financial markets attempt to do on a daily basis. It’s all about preserving capital in times of fear and hunting for a profit in times of greed.
For example; if equity shares prices are rapidly climbing then this is likely a risk on environment because traders are hunting for a profit. If share prices are getting beaten up and falling hard then this is probably a risk off market because money is coming out of equity shares. Keep in mind, if money is coming out of one market, such as equities, then that money will typically go into assets that are considered safe such as government-issued bonds.
Most money managers have a legal mandate to keep a large percentage of the money they have from investors actually invested in the markets. This explains why when money comes out of one asset class it tends to move into another asset class. Money needs to keep moving and it can’t do so if it is being held as cash on the books.
The direction of equity share indices, such as the S&P 500 or the DAX, can be a valuable leading indicator when determining the overall health of a particular economy. One of the old popular beliefs in economic circles is that a healthy stock market is a good measure of a healthy economy that the stock market belongs to. This is because if people are continuing to buy up equities then we have a risk on market that is looking to gain a nice yield or a healthy profit. When the market goes risk on this means that market participants are not worried about the health of the economy and are willing to put their money at risk because they think there is a good chance of making a nice profit.
Shares are also highly sensitive to corporate earnings news. If stock prices rise faster than the current and or projected corporate earnings then investors might become concerned that the price-to-earnings ratio or P/E ratio is too high and the stocks are now overvalued. This in turn could potentially cause a sell off until the actual earnings make sense with the P/E ratios for companies.
Conversely, lower P/E ratios may indicate cheap prices for shares and a reason to start buying stocks again. This typically happens as an economy is expected to turn the corner out of a recession and into a growth period again. This is the time that the market is attempting to price in future positive expectations and make some good money at the same time. The early bird gets the worm so to speak.
This is also a good time to point out that what the market "Expects" for the future is just as, if not more, important than what is actually happening currently in the economy. This is because it’s the expectations of the market that moves price before those expectations actually become reality. This is the market's discounting mechanism and in equity indexes, it is generally thought to price in expectations of 3 to 6 months from the current time. However, this time frame for pricing in expectations can and does change with changing economic climates.
Between 1972 and 1982 dramatic changes took place with the introduction of futures contracts on treasury bonds, currencies, and stock index futures. Since introducing these new futures contracts the world of futures trading has morphed from the simple and more traditional stocks and bonds futures contracts to a much larger and more complex futures trading marketplace with almost limitless asset classes available to trade. This has really opened up many new trading products that might be of potential value to certain types of traders and investors. It has also made the world of Intermarket Analysis and shifting money into and out of one asset class to another rather simple and efficient for market participants should they choose.
The Link between Bonds and Stocks
It has become clear that the direction and movement of futures markets can have an influence on stocks and commodities. Futures can give us early warning signs of the expectations on interest rates and inflation trends within certain economies. This will then affect the foreign exchange and stock markets.
The stock market is divided into many sectors and industry groups. If we look carefully we can see profitable sector rotation into and out of certain sectors within the equities markets. We can see this from certain futures price movements.
Sector rotation happens when large financial institutions such as pension funds, hedge funds, or large portfolio managers shift their investments from one sector of the economy or stock market to another. What happens is that these financial institutions sell one asset class and use the money from the sale to buy another asset class rather than just holding onto cash.
Not all sectors of the economy perform equally well at the same time. Portfolio managers will attempt to make higher returns by timing economic cycles because some assets will perform better in a healthy economic cycle and others will perform better in a recessionary economic climate. Sector rotation is all about being in the highest-performing asset at the right time in all cycles. At least that is the idea; it’s not exactly how it goes because, as we know, not all investment companies make money every year.
The basic premise of intermarket analysis is that all markets are linked in some way. Money goes into one asset class and when it is time to move out of that asset class it must move into another rather than simply being held as cash. Money is not typically held in cash because cash alone does not yield any return, it must be in an asset to potentially make a profit. Plus, why would an investor give their money to a portfolio manager who holds all cash rather than hunting for a profit in the markets? This would make no sense because the investor could clearly hold the cash himself without having to pay the typical high fees to a portfolio manager.
The direction of interest rate movements influences the stock market. In general, bond prices move in the opposite direction to interest rates and yields. Interest rates can be tracked in real time by watching the pricing of government bond futures. When bond prices are rising this would mean that yields are falling which is normally considered positive for stock prices. A comparison between the S&P 500 cash index and its related futures contract to that of the Treasury bond futures charts will show that they have generally moved in the same direction under normal market conditions. This is not always true, such as when the market is facing serious uncertainties, but for the most part, it’s a reliable correlation.
In the short term, sudden changes in the S&P 500 futures contract are often influenced by sudden changes in the Treasury bond futures contract. Sudden changes in the S&P 500 futures will of course have an effect on the pricing of the 500 stocks that make up the S&P 500. In the longer term, changes in the trend of the Treasury bond contract often warn of similar changes in the S&P 500 cash index. So we can come to the conclusion that bond futures can be viewed as a leading indicator for the stock market. In turn, bond futures are influenced by the trends in the commodity markets.
Let’s take a second to note that in a disinflationary environment, the correlation between bonds and stocks usually decouples. Basically, the correlation goes out the window until a more normal market environment comes back. During a disinflationary environment bond prices typically rise while stock prices fall.
Disinflation is simply a period or process of a slowing rate of inflation. It’s used to describe instances when the inflation rate has reduced marginally over the short term. Although it is used to describe periods of slowing inflation, it should not be confused with deflation which can be devastating to an economy. Deflation is a situation where the economy is actually shrinking rather than growing. This is the kiss of death to central bankers and they will do anything in their power to avoid deflation.
To put it overly simplistic, inflation is how much the prices of a standard basket of goods and services are going up and can therefore show us how much the rate that the economy is going up. A healthy developed economy should grow at a rate of around 2% over the long run.
The Link between Commodities and Bonds
Bonds are not just linked to equities and Forex; they are also linked to commodities.
Treasury bond prices are affected by the market expectations for future inflation readings. Remember, the market expectations are just as, if not more, important than what actually happens with inflation because the market will always attempt to discount what it believes will happen in the future right now in the current market.
Commodity prices are considered to be a leading indicator for inflationary trends. This is because we all use and consume commodities and if the prices are going up then we will obviously be paying more for commodities which causes inflation to grow. This means that commodity prices usually move in the opposite direction of bond prices. This is because if inflation is going up (i.e. commodities are going up in price) we can say that the economy is very likely doing well and that will cause bond prices to go down. In this situation, bond prices go down because bond issuers will pay lower premiums when times are good and higher premiums when times are bad. The issuer would only prefer to pay a higher premium when the economic outlook is looking bad because a higher premium will always be more enticing for people to invest their money.
If you perform a study of historical market charts dating back to the 1970’s they will show you that when there is a sudden upturn in commodity prices this is usually correlated with relatively equal declines in bond prices.
Intermarket analysis is an interesting subject and could command a lot of your time should you choose to go down that route. However, it’s just fine for now to understand that the dollar influences commodities, commodities influence bonds, and bonds influence stocks.
Deflation and its Effects
The Intermarket influences that we have described so far are based on statistical models dating back to the 1970s. In the United States, the ’70s was a period of runaway inflation. This high inflation environment favoured commodity and stock prices to go up. Since the Asian markets collapse in 1997 and its subsequent spread into the global economy, commodities have been hit hard with many boom and bust cycles. The Asian markets are such major consumers of commodities that the downturn has caused a lot of volatility. And it works in reverse, whenever the Asian markets are booming commodities boom right along with it. This has caused a long-term bullish run in bonds and non-commodity based equities.
Furthermore, the slower price rises observed during the late 2000s may now have turned into damaging deflation whether or not the economic data supports it. This is a situation called beneficial disinflation which causes the bond and stock markets to decouple from their normal correlations.
While the inverse relationship between bonds and commodities is maintained, deflation can cause the stock and bond markets to develop an inverse relationship as well which historically has not been the case. Therefore, while a relationship is always maintained, its nature may change in a disinflationary world and this relationship is what the global markets are currently trying to sort out at the time of this writing in 2017.
We are now in a time when traditional correlations may not be as effective as they once were in simpler times. The global markets are incredibly linked at this point but we have a situation where the Central banks of each individual country are not enacting their monetary policies as if they are linked. It will be interesting to see how all this recent printing of money in the form of quantitative easing changes or strengthens the traditional correlations.
For now, you have a basic introduction to historical correlations. You will quickly start to see how all the markets work together once you start immersing yourself in daily analysis. Understanding how the global financial world works can be fascinating once you really start to come to terms with the basics.
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