Key Points: 

• Intermarket Analysis provides an effective framework for understanding how individual markets and sectors relate to one another. Anyone who has an interest in any of the financial markets will benefit from knowing how Intermarket dynamics work.

• An informed trader acknowledges that all global financial markets are closely linked and have an impact on each other. For instance, analysis of stock market is incomplete without taking into account existing trends in the dollar, bond and commodity markets.

• Despite being backed up by correlation statistics, Intermarket Analysis is very visual and you are definitely going to see a lot of charts in the following articles (bar this piece of writing). Their usage will make comparisons between asset classes a lot easier to interpret.

We’ve all heard the quote “Risk comes from not knowing what you’re doing.” In our interconnected world, trying to trade the markets without Intermarket Analysis is like trying to drive a car at full speed for the entire journey – the engine will be at stress, will heat up more than advisable, the car may become unstable and may cause you to loose control – in other words, it is very dangerous. It is crystal clear that focusing one’s attention on only one financial market in isolation – whether it is the U.S. Stock Market or Gold Futures or any other – without taking into account what is happening in the remaining markets leads to a greater likelihood of missing vital directional clues. Despite that, most traders focus solely on one market at a time missing the forest for the trees. The truth is that all financial markets are interrelated and we will be studying how these are related to each other enabling you to anticipate market peaks, troughs, continuation or reversal patterns!

How can Intermarket work be performed?

The visual inspection of a comparison chart of one asset class overlapped by the chart of another asset class is the easiest methodology for this analysis. In addition, a custom ratio of prices of two different asset classes can also be calculated to assess past relations and predict future directions. Along with these two methods, the use of correlation coefficients is absolutely necessary to back up Intermarket relationships.

Diversification and Asset Allocation process

Diversification is the foundation of portfolio management. You are able either to substantially reduce or eliminate unsystematic/diversifiable risk without reducing expected return by combining uncorrelated, low or negatively correlated asset classes in a well-diversified portfolio. These correlations between classes tend to roughly hold* over time and this information help investors to ascertain the best places to put their money at a specific point of the market cycle. Whatever the relationship is – leading, lagging or divergent responses to economic situation – strong positively correlated markets can be expected to move in the same direction whereas strong negatively correlated markets are likely to move in opposite ways.Therefore, determining correlations amongst different asset classes may provide an insight into the future directional movement of the asset you propose to trade. As a step forward, linear regressions may be used to forecast the future price trend of an asset class based on its correlation with multiple related asset classes. For instance, during periods of falling stock markets, some bonds are attractive diversification candidates, acting as a buffer. Intermarket analysis is, therefore, key to the asset allocation process and it is crucial to improve the risk adjusted return of a portfolio – having an awareness of some intermarket linkages can aid you to know which asset classes to over or underweight at the appropriate time.

Should we, therefore, get rid of technical and fundamental analysis?

Put simply: No way! Intermarket work is neither intended to be the only methodology of analyzing assets nor taking over fundamental and technical analysis as the most important and primary methodologies used to analyze an individual market. Nevertheless, it is still a key variable and ought to be taken into the equation alongside other analytical tools or techniques so as to add security to the decision-making process. Put differently, when in doubt, you should look to related markets for valuable clues.

Imagine the process of analyzing stocks. Would not be nice to add an evolutionary dimension to the so-called “traditional” analysis (i.e. technical and fundamental analysis) and be able to achieve a better return on investment? More often than not, readings derived from technical analysis can be misleading and the study of other related markets, such as bonds and commodities, may provide an insight into the future direction of the stock market.

A stock trader should pay attention to the bond market – bond prices provide a useful confirming indication and often change direction before stock prices as well as informing which direction interest rates are taking – whereas bond traders ought to watch commodity markets – which will inform us which direction inflation rates are heading – and commodity traders should pay close attention to the trend of the U.S. Dollar – this currency, for example, usually trades in the opposite direction of the commodity markets. Note that these typical market relationships are developed in an inflationary economic environment. If not (i.e. threat of a deflationary environment) certain relationships will change.

Oh my! But this stuff really works 100%?

Well, as Benjamin Franklin once said “in this world nothing can be said to be certain, except death and taxes”. Do not get me wrong, there will be times when Intermarket relationships appear to either have vanished or to be temporarily out of the expected correlation. And what should you be doing when “traditional” analysis is not consistent with Intermarket analysis? The former is privileged and followed but with extra caution as you know that probably one of these analyses is giving false readings. In this case, you might want to go back and reexamine your individual conclusions.  However, there will be other times when the outcome of both analysis are the same, thus enabling traders to feel more reassured and act/trade accordingly.

What will come next?

There are an infinite number of relationships that exist between markets, but our discussions will be limited to those that I have found most useful and that I believe carry the most significance. The four asset classes involved in intermarket work are bonds, stocks, commodities, and currencies.

The crucial link between the Commodities and the bond market, which is the most important relationship in the intermarket picture, will be examined in more depth in this piece of writing. The real breakthrough in intermarket work comes with the recognition of how commodity markets and bond prices are linked.

*Bear in mind that Intermarket relationships and correlations are neither fixed nor static in time. For the sake of simplicity, we have stated that they “roughly hold over time”. To be more accurate, they sometimes change for short periods. Positive correlations between assets classes may turn into negative and vice-versa. Correlations fluctuate continuously over time and they may simply strengthen, weaken or may simply cease to exist. Due to this, you should focus on the prevailing historic correlation between two related asset classes before a final allocation decision is made.