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Intermarket Analysis Part 1
Introduction
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 on 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. Much of the material for this article comes from John Murphy's book and his postings in the Market Message at Stockcharts.com.
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Inflationary Relationships
The intermarket relationships depend on the forces of inflation or deflation. In a "normal" inflationary environment, stocks and bonds are positively correlated. This means they both move in the same direction. The world was in an inflationary environment from the 1970's to the late 1990's. These are the key intermarket relationships in a inflationary environment:
- A POSITIVE relationship between bonds and stocks
- An INVERSE relationship between interest rates and stocks
- Bonds usually change direction ahead of stocks
- An INVERSE relationship between commodities and bonds
- A POSITIVE relationship between commodities and interest rates
- Commodities usually change direction after stocks
- An INVERSE relationship between the US Dollar and commodities
POSITIVE: When one goes up, the other goes up also. INVERSE: When one goes up, the other goes down. Interest rates move up when bonds move down
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In an inflationary environment, stocks react positively to falling interest rates (rising bond prices). Low interest rates stimulate economic activity and boost corporate profits. As interest rates fall and the economy strengthens, demand for commodities increases and commodity prices rise. Keep in mind that an "inflationary environment" does not mean runaway inflation. 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 1998. It started with the collapse of the Thai Baht in the summer of 1997 and quickly spread to neighboring countries to become known as Asian currency crisis. Asian central bankers raised interest rates to support their currencies, but high interest rates choked their economies and compounded the problems. 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 decline. This marked a decoupling between stocks and bonds that would last for many years. Big deflationary events continued as the Nasdaq bubble burst in 2000, the housing bubble burst in 2006 and the financial crisis hit in 2007.
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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 visa versa. By extension, this also means that stocks have a positive relationship with interest rates. Yes, stocks and interest rates rise together.
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Obviously, deflationary forces change the whole dynamic. Deflation is negative for stocks and commodities, but positive for bonds. A rise in bond prices and fall in interest rates increases the deflationary threat and this puts downward pressure on stocks. Conversely, a decline in bond prices and rise in interest rates decreases the deflationary threat and this is positive for stocks. The list below summarizes the key intermarket relationships during a deflationary environment.
- An INVERSE relationship between bonds and stocks
- A POSITIVE relationship between interest rates and stocks
- An INVERSE relationship between commodities and bonds
- A POSITIVE relationship between commodities and interest rates
- A POSITIVE relationship between stocks and commodities
- An 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.
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What are the effects of a rising Dollar? A countries currency is a reflection of its economy and national balance sheet. 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. In particular, oil 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 metals 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. The chart below shows a clear positive relationship between industrial metals and the S&P 500.
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Industrial metals and bonds rise for different reasons. Metals move when the economy is growing and/or when inflationary pressures are building. Bonds decline under these circumstances and rise when the economy is weak and/or deflationary pressures are building. A ratio of the two can provide further insights into economic strength/weakness or inflation/deflation. The ratio of industrial metal prices to bond prices will rise when economic strength and inflation are prevalent. This ratio will decline when the economic weakness and deflation are dominant.
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Staples/Discretionary Ratio
Chartists can also compare the performance of the consumer discretionary sector to the consumer staples sector for clues on the economy. Stocks in the consumer discretionary sector represent products that are optional. These industry groups include apparel retailers and produces, shoe retailers and produces, restaurants and autos. Stocks in the consumer staples sector represent products that are necessary, such as soap, toothpaste, groceries, beverages and medicine. The consumer discretionary sector tends to outperform when the economy is buoyant and growing. This sector underperforms when the economy is struggling or contracting.
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Chartists can compare the performance of these two with a simple ratio chart of the Consumer Discretionary SPDR (XLY) divided by the Consumer Staples SPDR (XLP). The chart above shows this ratio with the S&P 500. The ratio was rather choppy in 2004, 2005 and 2006. A strong downtrend took hold in 2007 as the consumer discretionary sector underperformed the consumer staples sector. Put another way, the consumer staples sector outperformed the consumer discretionary sector. Also notice that this ratio peaked ahead of the S&P 500 in 2007 and broke support ahead of the market. The ratio bottomed ahead of the S&P 500 in late 2008 and broke resistance as the S&P 500 surged off the March 2009 low.
Business Cycle
The graph below shows the idealized business cycle and the intermarket relationships during a normal inflationary environment. This cycle map is based on one shown in the Intermarket Review by Martin J. Pring (Pring Research). The business cycle is shown as a sine wave. The first three stages are part of an economic contraction (weakening, bottoming, strengthening). Stage 3 shows the economy in a contraction phase, but strengthening after a bottom. As the sine wave crosses the centerline, the economy moves from contraction to the three phases of economic expansion (strengthening, topping and weakening). Stage 6 shows the economy in an expansion phase, but weakening after a top.
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- Stage 1 shows the economy contracting and bonds turning up as interest rates decline. Economic weakness favors loose monetary policy and the lowering of interest rates, which is bullish for bonds.
- Stage 2 marks a bottom in the economy and the stock market. Even though economic conditions have stopped deteriorating, the economy is still not at an expansion stage or actually growing. However, stocks anticipate an expansion phase by bottoming before the contraction period ends.
- Stage 3 shows a vast improvement in economic conditions as the business cycle prepares to move into an expansion phase. Stocks have been rising and commodities now anticipate an expansion phase by turning up.
- Stage 4 marks a period of full expansion. Both stocks and commodities are rising, but bonds turn lower because the expansion increases inflationary pressures. Interest rates start moving higher to combat inflationary pressures.
- Stage 5 marks a peak in economic growth and the stock market. Even though the expansion continues, the economy grows at a slower pace because rising interest rates and rising commodity prices take their toll. Stocks anticipate a contraction phase by peaking before the expansion actually ends. Commodities remain strong and peak after stocks.
- Stage 6 marks a deterioration in the economy as the business cycle prepares to move from an expansion phase to a contraction phase. Stocks have already been moving lower and commodities now turn lower in anticipation of decreased demand from the deteriorating economy.
Keep in mind that this is the ideal business cycle in an inflationary environment. Stocks and bonds advance together in stages 2 and 3. Similarly, both decline in stages 5 and 6. This would not be the case in a deflationary environment, when bonds and stocks would move in opposite directions.
