What is Intermarket Analysis?
Intermarket analysis involves studying the movement across various markets to gain insight into the likely developments that may occur within the market being traded. Understanding the correlation between certain markets and how the movement in one sector is apt to affect the direction of another provides a bigger picture perception of the arena in which one is trading.
In its truest form, inter-market analysis pertains to the relationships between the most important classes of assets. These assets are stock, bonds, currencies and commodities. The correlations between these markets provide valuable information in regard to the business and economic cycles that are occurring.
The Relationship Basis of Intermarket Analysis
John Murphy’s book, “Intermarket Analysis” states that the most clearly defined inter-market relationships are those between stocks and bonds, between bonds and commodities, and between commodities and the US Dollar.
One of the biggest factors influencing these inter-market relationships is inflation or deflation.
Inflation is the rate at which prices rise, and the average inflation rate for the United States was 3.33 percent between 1914 and 2014.
Deflation occurs when prices fall as a result of supply outweighing demand, and such a situation occurred from around 1998.
When the inflation rate is at a typical level, the resulting economic state of affairs is deemed an inflationary environment. This is accompanied by a positive correlation between stocks and bonds, meaning that when one rises, the other will also rise. A very useful fact is that bonds change direction before stocks, so a reversal in the movement of bond prices can offer a signal that stocks will follow suit. An inflationary environment produces an inverse relationship between bonds and commodities and also between the US Dollar and commodities. An inverse relationship means that when one rises, the other will fall.
During a deflationary period, some of these inter-market relationships shift, with the most important change being that stocks and bonds experience an inverse relationship. This results in a positive correlation between stocks and interest rates, as they rise in synch. The inverse relationship between bonds and commodities and also between the US Dollar and commodities remains the same as in an inflationary period, but a positive correlation between stocks and commodities emerges during a time of deflation.
Using Intermarket Analysis in Sector Rotation
A practical application of inter-market analysis can be made when practicing sector rotation. It is typical that an economic slowdown will be accompanied by a rise in stocks for energy and consumer staples. According to John Murphy, in the event that the consumer staples sector becomes a front-runner, a decline in stock prices can be expected to ensue.
It also stands to reason that many commodities will be influenced by the performance of other commodities, so a broad view across the spectrum always results in better informed trading decisions. Cheaper oil prices, in particular, tend to result in lower commodity prices.
How Effective is Inter-market Analysis?
Inter-market analysis can provide worthwhile insight into the probable movement of markets, especially for longer-term analysis. Understanding the correlation between key asset classes can also supply significant confirmation for other forms of analysis. However, no one form of analysis is ever failsafe, or designed to be used as a sole method, and on a short-term basis, inter-market analysis may be rendered ineffective by events which disrupt the usual relationships.