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The Butterfly Effect: Using Intermarket Analysis and ETFs

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March 8, 2016
The Butterfly Effect: Using Intermarket Analysis and ETFs

Commodities flutter and real estate stocks react, sometimes in unexpected locales. That means intermarket analysis and broad ETFs can be an important piece of your investing approach.

In the movie Jurassic Park, actor Jeff Goldblum enlightens viewers on the “butterfly effect,” the phenomenon whereby a small change at one place in a complex system can have significant effects elsewhere. “A butterfly can flap its wings in Peking and in Central Park you get rain instead of sunshine,” Goldblum’s character warns. Ray Bradbury lovers will recall a similar theme in A Sound of Thunder, where one stray step from the trail by time-traveling hunters could change the future forever.

No matter the source, there’s a lesson here for investors: if you learn how global economies, global markets, and typical market cycles interlace, you can trace much of the cause and effect that moves investments. Researchers call it “intermarket analysis” and it can be an important piece of a diverse investing approach. Armed with such knowledge, you might participate in big market moves in places you might have otherwise ignored, or hop on trends because you anticipate a ripple effect. Further, you might preemptively hedge your holdings against downturns. What’s new, however, is that the proliferation of exchange-traded funds (ETFs) to help investors capture global markets makes such research possible for self-directed traders and investors. In fact, your decision to trade or not to trade ETFs doesn’t preclude their use as a globe-trekking, cross-market tool. More on which ETFs may be candidates to get the researcher’s job done later.

History Lessons

First, we’ll study the relationships between the main asset classes: stocks, bonds, currencies, and commodities, including determining which correlate under typical circumstances and which “decouple.”

Generally speaking, correlation breaks down like this: commodities are a tangible good that must be purchased with currency and so with global exchange rates compared to the “reserve” U.S. dollar, there’s often a negative correlation between currencies and commodities. Consider that a firmer dollar makes commodities more expensive so they’re likely to be less desirable. When commodities and currencies move, so do interest rates, which are in effect the “cost” of money. Higher commodity prices tend to be considered inflationary so interest rates rise to compensate. This means commodities and interest rates tend to move in the same direction (remember: bond prices and interest rates move opposite one another). Short-term stock and bond prices usually decouple because they compete for investor demand yet longer term, it’s a different story, as falling interest rates can be pro-expansion to a point after which they again become inflationary.

In the early 1980s, gold hit a major price top, as did all commodities, but as their run-up fizzled (popped one might say, if we’re talking about bubbles), Treasury yields peaked at 16% before pulling back. Stocks kicked off a bull run that stretched from 1982 until 2000 when Internet stocks deflated and tugged the broader market down. From there, the U.S. dollar declined and gold rallied anew. Now, consider this global example: if gold beats its wings and surges in price, where might the market move to take advantage of rising values?

Beyond simply investing in a single gold-mining stock or a group of gold stocks via an ETF, there are other mutual funds or ETFs that might be considered versus more-expensive gold. For instance, Australia and South Africa derive much of their Gross Domestic Product from precious metals. The takeaway: the price of gold tends to be positively correlated with currency ETFs from these countries. And that relationship might further trickle to other sectors of their economy such as real estate, or to the economies of smaller, neighboring trade partners like New Zealand. Keep in mind, the inverse could happen if gold goes south.

It’s a lot to take in. Stick with me!

Score Keepers

The good news? There’s a veritable “cheat sheet” to help keep track of intermarket directional trade or trends, including market-versus-market, and region-versus-region, comparisons. For instance, let’s look at a basket of ETFs as a research tool. Simply follow and chart some major symbols to collect more nuggets of market intelligence (you can decide conclusively about trading ETFs another time).

Step one: identify intermarket posture. This means you must define general trends in multiple asset classes. Is the mood “risk accepting,” meaning stocks, commodities, real estate investment trusts (REITs), and certain corporate bonds are in demand? Or is it “risk averse,” with participants favoring traditionally defensive positions in Treasury bonds, cash, the U.S. dollar, the Swiss franc, and bearish stock plays?

Now, let’s look at some ETFs that may help identify when major posture shifts might be happening, e.g., commodities moving before stocks, and currencies moving before commodities. Keep in mind there can be overlap before clear-cut trends emerge.

Your risk-accepting bucket might include:

  • Broad U.S. stock-tracking ETFs such as SPDR S&P 500 (SPY), iShares Russell 2000 (IWM), Nasdaq 100-based PowerShares QQQ (QQQ), and SPDR Dow Jones Industrial Average (DIA)

  • The all-world iShares MSCI ACWI (ACWI), which is about 45% U.S. and 55% international

  • The emerging-market focused iShares MSCI EAFE (EFA) and iShares MSCI Emerging Markets Index (EEM)

  • CurrencyShares Australian Dollar (FXA) and CurrencyShares Canadian Dollar (FXC); and iShares Dow Jones U.S. Real Estate (IYR)

  • ETFs that track gold, silver, U.S. oil, the commodity index, and agriculture

Your risk-averse bucket might include:

  • iShares Barclays 20+ Year Treasury Bond (TLT)

  • iShares Barclays 7-10 Year Treasury (IEF)

  • iShares Barclays Aggregate Bond (AGG)

  • iShares Barclays Treasury Inflation-Protected (TIP)

  • PowerShares DB U.S. Dollar Index Bullish (UUP)

  • CurrencyShares Swiss Franc (FXF)

  • CurrencyShares Japenese Yen (FXY)

You might consider this collection of intermarket tickers your nature-watching tools. They might help you identify the moment the wings flutter. How you prepare for what’s next is up to you.

Editor’s Note: This article was originally published in August 2013.

Carefully consider the investment objectives, risks, charges, and expenses of an exchange traded fund before investing. A prospectus, obtained by calling 800-669-3900, contains this and other important information about an investment company. Read carefully before investing.

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