Intermarket Relationships: Following The Cycle

By Cory Mitchell AAA

The market is a big, confusing beast. With multiple indexes, stock types and categories, it can be overwhelming for the eager investor. But by understanding how the different markets interact with each other, the bigger picture can become much clearer. Observing the relationship between commodities, bond prices, stocks and currencies can also lead to smarter trades.

TUTORIAL: Advanced Bond Concepts

In most cycles, there is a general order in which these four markets move. By watching all of them, we are better able to assess the direction in which a market is shifting. All four markets work together. Some move with each other, and some against. Read on to find out how the cycle works and how you can make it work for you. (For background reading, see Understanding Market Cycles - The Key To Market Timing and The Stock Cycle: What Goes Up Must Come Down.)

The Market Push and Pull
Let's take a look at how commodities, bonds, stocks and currencies interact. As commodity prices rise, the cost of goods is pushed up. This increasing price action is inflationary, and interest rates also rise to reflect the inflation. Since the relationship between interest rates and bond prices is inverse, bond prices fall as interest rates rise.

Bond prices and stocks are generally correlated. When bond prices begin to fall, stocks will eventually follow suit and head down as well. As borrowing becomes more expensive and the cost of doing business rises due to inflation, it is reasonable to assume that companies (stocks) will not do as well. Once again, we will see a lag between bond prices falling and the resulting stock market decline.

The currency markets have an impact on all markets, but the main one to focus on is commodity prices. Commodity prices affect bonds and, subsequently, stocks. The U.S. dollar and commodity prices generally trend in opposite directions. As the dollar declines relative to other currencies, the reaction can be seen in commodity prices (which are based in U.S. dollars). (For more insight, see Commodity Prices And Currency Movements.)

The table below shows the basic relationships of the markets. The table moves from left to right and the starting point can be anywhere in the row. The result of that move will be reflected in the market action to the right.

Currency: Ý Commodities: ß Bond Prices: Ý
Stocks: Ý
Currency: ß Commodities: Ý Bond Prices: ß Stocks: ß

Remember that there are response lags between each of the markets' reactions - not everything happens at once. During that lag, many other factors could come into play.

So, if there are so many lags, and sometimes inverse markets are moving in the same direction when they should be moving in opposite directions, how can the investor take advantage?

Application
Intermarket analysis is not a method that will give you specific buy or sell signals. However, it does provide an excellent confirmation tool for trends, and will warn of potential reversals. As commodity prices escalate in an inflationary environment, it's only a matter of time before a dampening effect reaches the economy. If commodities are rising, bonds have started to turn lower, and stocks are still charging higher. These relationships will eventually overcome the bullishness in stocks. Stocks will be forced to retreat; it's only a matter of when.

As mentioned, commodities rising and bonds starting to turn down is not a signal to sell in the stock market. It is simply a warning that a reversal is extremely probable within the next couple months to a year if bonds continue to turn lower. There still could be excellent profits from the bull market in stocks during that time. (Learn about the different types of markets in Digging Deeper Into Bull And Bear Markets.)

What we need to watch for is stocks taking out major support levels or breaking below a moving average (MA) after bond prices have already started to fall. This would be our confirmation that the intermarket relationships are taking over and stocks are now reversing. (To learn more, read Market Reversals And How To Spot Them.)

When Doesn't It Work?
There are always relationships between these markets, yet there are times the relationships mentioned above will seem to break down. During the Asian collapse of 1997, the U.S. markets saw stocks and bonds decouple (stocks fell as bonds rose, and stocks rose as bonds fell). This violates the positive correlation relationship of bond and stock prices. So why did this occur? The typical market relationships assume an inflationary economic environment. So, when we move into a deflationary environment, certain relationships will shift. (For more insight, see What does deflation mean to investors?)

Deflation is generally going to push the stock market lower. Without growth potential in stocks, it is unlikely they will head higher. Bond prices, on the other hand, are going to move higher to reflect falling interest rates (remember, interest rates and bond prices move in opposite directions). Therefore, we must be aware of what kind of economy we are in, in order to better determine whether bonds and stocks will be positively or negatively correlated.

At certain times, one market will not seem to move at all. However, just because one piece to the puzzle is not responding doesn't mean that the other rules don't still apply. For example, if commodity prices have stalled but the U.S. dollar is falling, this is still likely bearish for bond and stock prices. The basic relationships still hold, even if one market is not moving. This is because there are always multiple factors at work in the economy.

Also, as companies become increasingly global, these companies play large roles in the direction of the stock market. As companies continue to expand, the relationship between the stock market and currencies may become inversely related. This is because as companies do more and more business overseas, the value of the money brought back to the U.S. grows as the dollar falls, which increases earnings. To effectively apply intermarket analysis, it is always important to understand the shifting dynamics of global economies when deviations are seen in asset class relationships.

The Bottom Line
Intermarket analysis is a valuable tool when investors understand how to use it. However, we must be aware of the type of economic environment we are in over the long term, and adjust the relationships we will see accordingly. Intermarket analysis should be used as a tool to judge when a certain market is likely to reverse, or whether a trend is likely to continue.

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