INTERMARKET ANALYSIS

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INTERMARKET ANALYSIS

In 1991, I wrote a book entitled Intermarket Technical Analysis. That book described the interrelationships between the various financial markets, which are universally accepted today. The book provided a guide, or blueprint, to help explain the sequence that develops among the various markets and to show how interdependent they really are. The basic premise of intermarket analysis is that all financial markets are linked in some way. That includes international markets as well as domestic ones. Those relationships may shift on occasion, but they are always present in one form or another. As a result, a complete understanding of what’s going on in one market—such as the stock market—isn’t possible without some understanding of what’s going on in other markets. Because the markets are now so intertwined, the technical analyst has an enormous advantage. The technical tools described in this book can be applied to all markets, which greatly facilitates the application of intermarket analysis. You’ll also see why the ability to follow the charts of so many markets is a tremendous advantage in today’s complex marketplace.

PROGRAM TRADING: THE ULTIMATE LINK

Nowhere is the close link between stocks and futures more obvious than in the relationship between the S&P 500 cash index and the S&P 500 futures contract. Normally, the futures contract trades at a premium to the cash index. The size of that premium is determined by such things as the level of short term interest rates, the yield on the S&P 500 index itself, and the number of

days until the futures contract expires. The premium (or spread) between S&P 500 futures over the cash index diminishes as the futures contract approaches expiration. (See Figure 17.1.) Each day, institutions calculate what the actual premium should be—called fair value. That fair value remains constant throughout the trading day, but changes gradually with each new day. When the futures premium moves above its fair value to the cash index by some predetermined amount, an arbitrage trade is automatically activated—called program buying. When the futures are too high relative to the cash index, program traders sell the futures contract and buy a basket of stocks in the S&P 500 to bring the two entities back into line. The result of program buying is positive for the stock market since it pushes the S&P 500 cash index higher. Program selling is just the opposite and occurs when the premium of the futures over the cash narrows too far below its fair value. In that case, program selling is activated which results in the buying of S&P 500 futures and selling of the basket of stocks. Program selling is negative for the market. Most traders understand this relationship between the two related markets. What they don’t always understand is that the sudden moves in the S&P 500 futures contract, which activate the program trading, are often caused by sudden moves in other futures markets—like bonds.

Figure 17.1 S&P 500 futures normally trade at a premium to the cash index as shown in this chart. Notice that the premium narrows as the March contract nears expiration.

THE LINK BETWEEN BONDS AND STOCKS

The stock market is influenced by the direction of interest rates. The direction of interest rates (or yield) can be monitored on a minute-to-minute basis by tracking the movements in the Treasury Bond futures contract. Bond prices move in the opposite direction of interest rates or yields. Therefore, when bond prices are rising, yields are falling. That is normally considered positive for stocks.* Falling bond prices, or rising yields, are considered negative for stocks. From a technician’s point of view, it is very easy to compare the charts of Treasury Bond futures with the charts of either the S&P 500 cash index or its related futures contract. You’ll see that they have generally trended in the same direction. (See Figure 17.2.) On a short term basis, sudden changes in trend in the S&P 500 futures contract are often influenced by sudden changes in the Treasury Bond futures contract. On a longer range basis, changes in the trend of the Treasury Bond contract often warn of similar turns in the S&P 500 cash index itself. In that sense, bond futures can be viewed as a leading indicator for the stock market. Bond futures, in turn, are usually influenced by trends in the commodity markets.

* In a deflationary environment, bonds and stocks usually decouple. Bond prices rise while stock prices fall.

Figure 17.2 Rising bond prices are usually good for stock prices. The bond market bottoms in 1981, 1984, 1988, 1991, and 1995 led to major upturns in stocks. Bond peaks in 1987, 1990, and 1994 warned of bad stock market years.

THE LINK BETWEEN BONDS AND COMMODITIES

Treasury Bond prices are influenced by expectations for inflation. Commodity prices are considered to be leading indicators of inflationary trends. As a result, commodity prices usually trend in the opposite direction of bond prices. If you study the market’s history since the 1970s, you’ll see that sudden upturns in commodity markets (signaling higher price inflation) have usually been associated with corresponding declines in Treasury Bond prices. The flip side of that relationship is that strong Treasury Bond gains have normally corresponded with falling commodity prices. (See Figure 17.3). Commodity prices, in turn, are impacted by the direction of the U.S. dollar.

Figure 17.3 Commodity prices and bond prices normally trend in opposite directions as shown here. The bond bottoms in the spring of 1996 and 1997 coincided with major peaks in commodity prices (see boxes).

THE LINK BETWEEN COMMODITIES AND THE DOLLAR

A rising U.S. dollar normally has a depressing effect on most commodity prices. In other words, a rising dollar is normally considered to be noninflationary. (See Figure 17.4.) One of the commodities most effected by the dollar is the gold market. If you study their relationship over time, you’ll

see that the prices of gold and the U.S. dollar usually trend in opposite directions. (See Figure 17.5.) The gold market, in turn, usually acts as a leading indicator for other commodity markets. So, if you’re analyzing the gold market, it’s necessary to know what the dollar is doing. If you’re studying the commodity price trend in general (using one of the better known commodity price indexes), it’s necessary to know what the gold market is doing. The fact of the matter is that all four markets are linked—the dollar influences commodities, which influence bonds, which influence stocks. To fully comprehend what’s happening in any one asset class, it’s necessary to know what’s happening in the other three. Fortunately, that’s easily done by simply looking at their respective price charts.

Figure 17.4 A rising dollar normally has a depressing effect on commodity markets. In 1980, the dollar bottom coincided with a major peak in commodities. The dollar bottom in 1995 contributed to a sharp decline in commodities a year later.

Figure 17.5 The U.S. Dollar and gold prices usually trend in opposite directions as shown in this example. Gold prices, in turn, usually lead other commodities.

STOCK SECTORS AND INDUSTRY GROUPS

An understanding of these intermarket relationships also sheds light on the interaction between the various stock market sectors and industry groups. The stock market is divided into market sectors which are then subdivided into industry groups. These market categories are influenced by what’s happening on the intermarket scene. For example, when bonds are strong and commodities weak, interest rate-sensitive stock groups—such as the utilities, financial stocks, and consumer staples—usually do well relative to the rest of the stock market. At the same time, inflation-sensitive stock groups—like gold, energy, and cyclical stocks—usually underperform. When commodity markets are strong relative to bonds, the opposite is the case. By monitoring the relationship between Treasury Bond prices and commodity prices, you can determine which sectors or industry groups will do better at any given time.

Since there is such a close relationship between stock market sectors and their related futures markets, they can be used in conjunction with each other. Utility stocks, for example, are closely linked to Treasury Bond prices. (See Figure 17.6.) Gold mining shares are closely linked to the price of gold. What’s more, the related stock groups often tend to lead their respective

futures markets. As a result, utility stocks can be used as leading indicators for Treasury Bonds. Gold mining shares can be used as leading indicators for gold prices. Another example of intermarket influence is the impact of the trend of oil prices on energy and airline stocks. Rising oil prices help energy shares but hurt airlines. Falling oil prices have the opposite effect.

Figure 17.6 There is usually very close linkage between bond prices and utilities. In addition, utilities often make their turns a little before bonds.

THE DOLLAR AND LARGE CAPS

Another intermarket relationship involves how the dollar affects large and small cap stocks. Large multinational stocks can be negatively impacted by a very strong dollar, which may make their products too expensive in foreign markets. By contrast, the more domestically oriented small cap stocks are less affected by dollar movements and may actually do better than larger stocks in a strong dollar environment. As a result, a stronger dollar may favor smaller stocks (like those in the Russell 2000), while a weaker dollar may benefit the large multinationals (like those in the Dow Industrial Average.)

INTERMARKET ANALYSIS AND MUTUAL FUNDS

It should be obvious that some understanding of these intermarket relationships can go a long way in mutual fund investing. The direction of the U.S. dollar, for example, might influence your commitment to small cap funds versus large cap funds. It may also help determine how much money you might want to commit to gold or natural resource funds. The availability of so many sector-oriented mutual funds actually complicates the decision of which ones to emphasize at any given time. That task is made a good deal easier by comparing the relative performance of the futures markets and the various stock market sectors and industry groups. That is easily accomplished by a simple charting approach called relative strength analysis.

RELATIVE STRENGTH ANALYSIS

This is an extremely simple but effective charting tool. All you do is divide one market entity by another—in other words, plot a ratio of two market prices. When the ratio line is rising, the numerator price is stronger than the denominator. When the ratio line is declining, the denominator market is stronger. Consider some examples of what you can do with this simple indicator. Divide a commodity index (such as the CRB Futures Price Index) by Treasury Bond futures prices. (See Figure 17.7.) When the ratio line is rising, commodity prices are outperforming bonds. In that scenario, futures traders would be buying commodity markets and selling bonds. At the same time, stock traders would be buying inflation sensitive stocks and selling interest-rate sensitive stocks. When the ratio line is falling, they would be doing the opposite. That is, they would sell commodities and buy bonds. At the same time, stock investors would be selling the golds, the oils, and the cyclicals, while buying the utilities, the financials, and consumer staples. (See Figure 17.8.)

Figure 17.7 The CRB Index/Treasury Bond ratio tells us which asset class is stronger. 1994 favored commodities, while 1995 favored bonds. The ratio took a sharp downturn in mid-1997 owing to the Asian crisis and fears of deflation.

Figure 17.8 During October 1997, the Asian crisis caused funds to flow out of cyclicals and into consumer staples, which coincided with a falling CRB/Bond ratio in Figure 17.7.

RELATIVE STRENGTH AND SECTORS

Many exchanges now trade index options on various stock market sectors. The Chicago Board Options Exchange has the greatest selection and includes such diverse groups as automotive, computer software, environmental, gaming, real estate, healthcare, retail, and transportation. The American and Philadelphia Stock Exchanges offer popular index options on banks, gold, oil, pharmaceuticals, semiconductors, technology, and utilities. All of these index options can be charted and analyzed like any other market. The best way to use relative strength analysis on them is to divide their price by some industry benchmark such as the S&P 500. You can then determine which are outperforming the overall market (a rising RS line) or underperforming (a falling RS line). Employing some simple charting tools like trendlines and moving averages on the relative strength lines themselves will help you spot important changes in their trend. (See Figure 17.9.) The general idea is to rotate your funds into those sectors of the market whose relative strength lines are just turning up, and to rotate out of those market groups whose relative strength lines are just turning down. Those moves can be implemented either with the index options themselves or through mutual funds that match the various market sectors and industry groups.

Figure 17.9 A relative strength (ratio) comparison of the PSE High Tech Index to the S&P 500. Simple trendline analysis helped spot the downturn in technology stocks during October 1997 and the upturn at year-end.

RELATIVE STRENGTH AND INDIVIDUAL STOCKS

Investors have two ways to go at that point. They can simply rotate their funds out of one market group into another and stop there. Or, if they wish, they can continue on to choose individual stocks within those groups. Relative strength analysis plays a role here as well. Once the desired index has been chosen, the next step is to divide each of the individual stocks within the index by the index itself. In that way, you can easily spot the individual stocks that are showing the greatest relative strength. (See Figure 17.10.) You can purchase the stocks showing the strongest ratio lines, or you can buy a cheaper stock whose ratio line may just be turning up. The idea, however, is to avoid stocks whose relative strength (ratio) lines are still falling.

Figure 17.10 A ratio analysis of Dell Computer versus the PSE High Tech Index at the end of 1997 showed Dell to be one of the better stock picks in the tech sector.

TOP-DOWN MARKET APPROACH

What we’ve described here is a top down market approach. You begin by studying the major market averages to determine the trend of the overall market. Then you select those market sectors or industry groups that are showing the best relative strength. Then you select individual stocks within those groups that are also showing the best relative strength. By incorporating intermarket principles into your decision making process, you can also determine whether the current market climate favors bonds, commodities, or stocks which can play a role in your asset allocation decisions. The same principles can also be applied to international investing by simply comparing the relative strength of the various global stock markets. And, finally, all of these technical tools described herein can be applied to charts of mutual funds as a final check on your analysis. All of this work is easily done with price charts and a computer. Imagine trying to apply fundamental analysis to so many markets at the same time.

DEFLATION SCENARIO

The intermarket principles described herein are based on market trends since 1970. The 1970s saw runaway inflation which favored commodity assets. The decades of the 1980s and 1990s have been characterized by falling commodities (disinflation) and strong bull markets in bonds and stocks. During the second half of 1997, a severe downturn in Asian currency and stock markets was especially damaging to markets like copper, gold, and oil. For the first time in decades, some market observers expressed concern that a beneficial disinflation (prices rising at a slower level) might turn into a harmful deflation (falling prices). To add to the concerns, producer prices fell on an annual basis for the first time in more than a decade. As a result, the bond and stock markets began to decouple. For the first time in four years, investors were switching out of stocks and putting more money into bonds and rate-sensitive stock groups like utilities. The reason for that asset allocation adjustment is that deflation changes the intermarket scenario. The inverse relationship between bond prices and commodities is maintained. Commodities fall while bond prices rise. The difference is that the stock market can react negatively in that environment. We point this out because it’s been a long time since the financial markets had to deal with the problem of price deflation. If and when deflation does occur, intermarket relationships will still be present but in a different way. Disinflation is bad for commodities, but good for bonds and stocks. Deflation is good for bonds and bad for commodities, but may also be bad for stocks.

The deflationary trend that started in Asia in mid-1997 spread to Russia and Latin America by mid-1998 and began to hurt all global equity markets. A plunge in commodity prices had an especially damaging impact on commodity exporters like Australia, Canada, Mexico, and Russia. The deflationary impact of falling commodity and stock prices had a positive impact on Treasury bond prices, which hit record highs. Market events of 1998 were a dramatic example of the existence of global intermarket linkages

INTERMARKET CORRELATION

Two markets that normally trend in the same direction, such as bonds and stocks, are positively correlated. Markets that trend in opposite directions, like bonds and commodities, are negatively correlated. Charting software allows you to measure the degree of correlation between different markets. A high positive reading suggests a strong positive correlation. A high negative reading suggests a strong negative correlation. A reading near zero suggests little or no correlation between two markets. By measuring the degree of correlation, the trader is able to establish how much emphasis to place on a particular intermarket relationship. More weight should be placed on those with higher correlations, and less weight on those closer to zero. (See Figure 17.11.)

Figure 17.11 The line along the bottom shows the positive correlation between T-bond prices and the S&P500. During the second half of 1997, the Asian crisis caused an unusual decoupling. Investors bought bonds and sold stocks.

In his book, Cybernetic Trading Strategies, Murray Ruggiero, Jr. presents creative work on the subject of intermarket correlations. He also shows how to use intermarket filters on trading systems. He demonstrates, for example, how a moving-average crossover system in the bond market can be

used as a filter for stock index trading. Ruggiero explores the application of state-of-the-art artificial intelligence methods like chaos theory, fuzzy logic, and neural networks to the development of technical trading systems. He also explores the application of neural networks to the field of intermarket analysis.

INTERMARKET NEURAL NETWORK SOFTWARE

One major problem with the study of intermarket relationships is that there are so many of them—and they’re all interacting at the same time. That’s where neural networks come into play. Neural networks provide a more quantitative framework for identifying and tracking the complex relationships that exist among the financial markets. Louis Mendelsohn, president of Market Technologies Corporation (25941 Apple Blossom Lane, Wesley Chapel, FL 33544; e-mail address: 45141@ProfitTaker.com; website URL: www.ProfitTaker.com/45141), was the first person to develop intermarket analysis software in the financial industry during the 1980s. Mendelsohn is the leading pioneer in the application of microcomputer software and neural networks to intermarket analysis. His VantagePoint software, first introduced in 1991, uses intermarket principles to trade interest rate markets, stock indexes, currency markets, and energy futures. VantagePoint uses neural network technology to detect the hidden patterns and correlations that exist between related markets.

CONCLUSION

This chapter summarizes the main points included in my book, Intermarket Technical Analysis. It discusses the ripple effect that flows from the dollar to commodities to bonds to stocks. Intermarket work also recognizes the existence of global linkages. What happens in Asia, Europe, and Latin America has an impact on U.S. markets and vice versa. Intermarket analysis sheds light on sector rotation within the stock market. Relative strength analysis is helpful for seeking out asset classes, market sectors, or individual stocks that are likely to outperform the general market. In his book, Leading Indicators for the 1990s, Dr. Geoffrey Moore shows how the interaction between commodity prices, bond prices, and stock prices follows a sequential pattern that tracks the business cycle. Dr. Moore substantiates the intermarket rotation within the three asset classes, and argues for their use in economic

forecasting. In doing so, Dr. Moore elevates intermarket work and technical analysis in general into the realm of economic forecasting. Finally, technical analysis can be applied to mutual funds like any other market (with some minor modifications). That being the case, all of the techniques discussed in this book can be applied right on the mutual fund charts themselves. Even better, the lower degree of volatility in mutual fund charts make them excellent vehicles for chart analysis. My latest book, The Visual Investor, deals more extensively with the subject of sector analysis and trading, and shows how mutual funds can be charted and then used to implement various trading strategies. (See Figure 17.12.)

Figure 17.12 Chart analysis can be done on mutual fund charts. You didn’t have to be a chart expert to see that Asia was headed for trouble by tracking this mutual fund.

MEASURING MARKET BREADTH

In the previous chapter, we described the top-down approach that is most commonly employed in stock market analysis. With that approach, you begin your analysis with a study of the health of the overall market. Then you work down to market sectors and industry groups. The final step is the study of individual stocks. Your goal is to pick the best stocks in the best groups in an environment when the stock market is technically healthy. The study of market sectors and individual stocks can be accomplished with the technical tools employed throughout this book—including chart patterns, volume analysis, trendlines, moving averages, oscillators, etc. Those same indicators can also be applied to the major market averages. But there’s another class of market indicators widely employed in stock market analysis whose purpose is to determine the health of the overall stock market by measuring market breadth. The data used in their construction are advancing versus declining issues, new highs versus new lows, and up volume versus down volume.

SAMPLE DATA

If you check the Stock Market Data Bank section of The Wall Street Journal (Section C, page 2) each day, you’ll find the following data for the previous trading day. The numbers shown are based on an actual day’s trading results.

Diaries
NYSE	Monday
Issues Traded	3,432
Advances	1,327

Declines	1,559
Unchanged	546
New highs	78
New lows	43
Adv vol (000)	248,215
Decl vol (000)	279,557
Total vol (000)	553,914
Closing tick	-135
Closing Arms (trin)	.96

The above figures are derived from New York Stock Exchange (NYSE) data. A similar breakdown is also shown for the NASDAQ and the American Stock Exchange. We’ll concentrate on the NYSE in this discussion. It just so happens that on that particular day the Dow Jones Industrial Average had gained 12.20 points. So the market was up as measured by the Dow. However, there were more declining stocks (1,559) than advancing stocks (1,327), suggesting that the broader market didn’t fare as well as the Dow. There was also more declining volume than advancing volume. Those two sets of figures suggest that market breadth was actually negative for that particular day—even though the Dow itself closed higher. The other figures present a more mixed picture. The number of stocks hitting new 52 week highs (78) was greater than those hitting new lows (43) suggesting a positive market environment. However, the closing tick (the number of stocks that closed on an uptick versus a downtick) was a negative, -135. That meant that 135 more stocks closed on a downtick than an uptick, a short term negative factor. The negative closing tick, however, is offset by a closing Arms (Trin) reading of .96 which is mildly positive. We’ll explain why that is later in the chapter. All of these internal market readings have one intended purpose—to give us a more accurate reading on the health of the overall market that isn’t always reflected in the movement of the Dow itself.