No Market Trades in a Vacuum: Using Intermarket Analysis

Traders often anxiously await an “aha” moment—that instant of clarity about a trading idea or a market’s next leg up or down. Well, as a Chinese proverb tells us: There are many paths to the top of the mountain. The same can be true of analyzing financial markets; there are many approaches to consider, including intermarket analysis.

Intermarket analysis tucks in with fundamental analysis—which drills down to price/earnings ratios and balance sheet data, among other factors. It can also pair with technical analysis—the study of chart trends and indicators. These paths of study have individual uses, but often intersect in many traders’ approach to the markets.

Specifically, intermarket analysis studies the relationships between asset classes, typically stocks, bonds, commodities, and currencies. It can help identify economic trends, investment cycles, and risk rotation. And that can help spawn broader trading ideas, reveal potential market turning points, or confirm other analysis methods.

Here are some traditional intermarket relationships:

• A rising dollar is considered negative for commodities prices, while a falling dollar is viewed as positive for commodities prices.
• Rising bond prices/falling interest rates are normally good for stocks, while falling bond prices/rising interest rates tend to be negative for stocks.
• Rising commodities prices are historically a sign of economic growth—good for the stock market and negative for bond prices.

“Consider a period when bonds are in high demand, possibly signaling a weakening global economy where investors are seeking relative safety,” explains Devin Ekberg. “Commodities would likely be negatively affected, partly because they’re considered riskier investments, and also because they typically fall when the global economy isn’t growing.

“The relationship between the two assets might give investors a clue as to the economic trend they find themselves in,” he adds.

Markets in Play Now

A rising U.S. dollar trend has been in place over the past year. The U.S. dollar is tied to many commodities, such as crude oil, simply because commodities are bought and sold on the world marketplace with dollars; it’s the medium of exchange, even when the U.S. isn’t involved in the trade.

“If you’re China and buying crude oil from Saudi Arabia, you’re still transacting in U.S. dollars,” says Ekberg.

Historically, there’s an inverse correlation between the dollar and commodities. That pattern has played out over the past year. From June 2014 to June 2015, the U.S. dollar index climbed 19.7%, while NYMEX West Texas Intermediate, or WTI, crude oil futures fell 43% (see figure 1). 

There tends to be a stronger impact on outright commodity prices, but commodity-related stocks can be affected as well.

“The price of the commodity itself is really a pure function of supply and demand,” says Ekberg. “Commodity-related stocks are impacted as well, but the impact is harder to predict due to the variability of a company’s financial statements, management, and strategy.”

The rising dollar trend has had several repercussions over the last year, according to Ekberg:

1. Commodity prices are trending down, particularly oil.
2. U.S. multinational stock earnings saw a drag from decreased profits overseas, but stocks generally moved higher, toward “full” valuation.
3. Bond prices moved higher, supported by increased foreign capital flows into the U.S. for its relative safety and higher yields compared to other established regions (Europe, for one).

At publishing time, commodities from grains to gold were in retreat on anticipation of a Federal Reserve interest rate hike. That’s likely to fuel existing dollar strength. Now, toss in softer global growth and a supply glut in many categories. Gold logged its steepest drop in almost two years. Crude oil futures prices were back near $50 a barrel and approaching a revisit of multi-year lows on dollar impact and an abundance of global supply.

Putting It to Use

Whether you are a long-term investor or a short-term trader, intermarket analysis can help you identify bigger economic cycles or short-term trading spots. Long-term investors may take a macroeconomic approach to intermarket analysis, making broad asset allocation decisions based on trends between asset classes.

When trading commodity futures on a multi-day to multi-week basis, many short-term traders may try to take advantage of the volatility created when asset classes are at their extremes.

“A common strategy is identifying relative extremes, and assuming that they’ll revert to their longer-term averages,” Ekberg notes.

When it comes to market extremes, however, longer-term investors may be best served by having patience and waiting for confirmation of a trend change before acting upon expected correlations.

“Markets can be irrational for longer than you think. Better to wait for evidence that the price trend is changing, rather than trying to call the tops and bottoms. Risk happens fast, particularly when commodities and currencies are involved,” Ekberg concludes.

In other words, reaching that “aha” moment from the mountaintop still requires careful footing.