CHAPTER 1

Intermarket Analysis: The Study of Relationships

This chapter covers the main points of intermarket analysis, starting with the observation that all markets are related. It will also introduce asset allocation and sector rotation strategies at various stages of the business cycle, and explain how stocks peak and trough before the economy. Other points include the important role played by crude oil, how exchange traded funds have revolutionized intermarket trading, the advantage of using charts, why viewing the big picture is important, intermarket implications for technical analysis, how its adds a new dimension to technical work, why it’s an evolutionary step, and why relationships change. It will end with a recap of intermarket principles.

■ All Markets Are Related

As the name implies, intermarket analysis is the study of how various financial markets are related to each other. 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.

That is no longer the case. Traditional chart analysis has taken a major evolutionary step over the last decade by adopting a more universal intermarket approach. I like to think that my two earlier books on intermarket analysis (published in 1991 and 2004) helped move things in that direction. It would be unthinkable today for a trader in any one of those four asset classes not to study trends in the other three.

JOHN’S TIPS

The four asset classes involved in intermarket work are bonds, stocks, commodities, and currencies.

Some understanding of how the different asset classes interact with each other is important for at least two reasons. First, such an 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. If you’re trading stocks, you should be watching bonds because bond prices usually trend in the opposite direction of stocks. In many cases, turns in the bond market actually precede turns in stocks. Bond yields are inversely correlated with bond prices. That being the case, falling bond yields (rising bond prices) can be a negative warning for stocks.

Figure 1.1 compares the yield on the 10‐year Treasury note to the S&P 500 during 2000. After peaking that January (first arrow), the bond yield started falling a lot faster than the stock market. By that spring, the bond yield had fallen to the lowest level in a year while the S&P 500 was still trending sideways (although the Nasdaq peaked that spring). The S&P 500 didn’t start falling until the fourth quarter of that year (second arrow) and entered a major bear market that lasted for more than two years. That’s a pretty dramatic example of falling bond yields giving early warning that the stock market was in trouble. It demonstrates how the bond market usually changes direction before stocks at major turning points and is often a leading indicator of the stock market. Figure 1.1 also demonstrates why it’s so important for stock analysts to take trends in the bond market into consideration.

If you’re a bond trader, you should be watching trends in commodity markets. A jump in commodity prices, for example, is usually associated with a drop in bond values. In another illustration of how one market impacts on another, a falling U.S. dollar usually results in rising commodity prices. And, as you’ll see later in the book, the direction of the U.S. currency helps determine the relative attractiveness of foreign stocks compared to those in the United States.

FIGURE 1.1 Drop in bond yield during 2000 warned of stock peak

■ Asset Allocation Strategies

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. Since 2002, for example, commodities have been the strongest asset class and are now recognized by Wall Street and the investing public as a viable alternative to bonds and stocks. The emergence of exchange‐traded funds (ETFs) has had a lot to do with the increasingly popularity of commodity trading. The same is true for foreign currency markets, which have also had a strong run since 2002.

Consider the relative performance of those four asset classes since the start of 2002 when the U.S. dollar started a major decline that eventually took it to a record low. During the 10‐year span starting in 2002, commodity prices gained 64 percent. By comparison, bond prices gained 23 percent, while U.S. stocks experienced a relatively modest gain of 9 percent. The main catalyst in the commodity upturn was a 32 percent drop in the U.S. dollar. That’s because the dollar and commodities trend in opposite directions. A falling dollar results in higher commodity prices.

JOHN’S TIPS

Commodity prices and foreign currencies trend in the same direction and in the opposite direction of the U.S. dollar.

Figure 1.2 compares the trend of the U.S. Dollar Index to the CRB Index of commodity prices between 2000 and 2008. It’s clear that the two markets trended in opposite directions. It can also be seen that the major upturn in commodity prices began during 2002 (up arrow) at the exact same time that the dollar started dropping (down arrow). The inverse relationship between the dollar and commodity markets is one of the most consistent and reliable relationships in intermarket work.

FIGURE 1.2 Dollar peak in 2002 led to major commodity upturn

Foreign currencies also benefit from a falling dollar. That’s especially true for currencies tied to countries that export commodities like Australia and Canada. During the 10 years starting in 2002, the Aussie dollar (boosted by rising commodity prices) gained 101 percent versus 50 percent for the euro. It’s clear that investors have benefited from the ability to expand their asset allocation choices beyond bonds and stocks. Exchange‐traded funds are a big reason why.

■ ETFs Have Revolutionized Intermarket Trading

Exchange‐traded funds have had a lot to do with expanding those choices into alternate assets like commodities and currencies. In fact, the explosive popularity of ETFs has revolutionized the world of intermarket trading and has made it increasingly easy to implement global intermarket strategies. During the 1990s, for example, the ability to incorporate commodities and currencies into one’s portfolio was almost impossible outside of the futures markets. The growing availability of ETFs has made investing in commodity and currency markets as easy as buying a stock on a stock exchange. Exchange‐traded funds can be used for virtually any asset class anywhere in the world. Mainly for that reason, we’ll be relying very heavily on ETFs throughout this book to show how markets interact and how to take advantage of those interactions. Another place where ETFs have become extremely popular is in implementing sector rotation strategies.

■ Sector Rotation and the Business Cycle

Intermarket analysis plays an important role in sector rotation strategies. The U.S. stock market is divided into market sectors (which are further subdivided into industry groups).

JOHN’S TIPS

The stock market has 10 sectors and approximately 90 industry groups.

Exchange‐traded funds are available that cover all market sectors (and most industry groups). That greatly facilitates the movement into and out of various market sectors at different stages of the business cycle. I’ll show you later in the book how to use intermarket principles (and some simple charting techniques) to spot leading and lagging market sectors for the purpose of ensuring that you’re in the leaders and out of the laggards. You’ll also learn how tracking sector rotation offers valuable insights into the direction of the stock market and the economy.

Near the start of a new bull market in stocks, economically sensitive groups like consumer discretionary stocks (which include retailers) usually do better than most other stocks. So do technology and transportation stocks, which are tied to the business cycle. Small-cap stocks also lead at market bottoms. Near market tops, those very same groups usually turn down first. Energy stocks (which are tied to the price of oil) have a tendency to become market leaders near the end of a bull market in stocks. Energy leadership is almost always a...