The market is a big, confusing beast. It can be overwhelming for the eager investor, particularly with multiple indexes, stock types and categories. That's why it is crucial to observe the relationship between four primary markets – commodities, bond prices, stocks and currencies – which not only makes the bigger picture become much clearer, but can also lead to smarter trades.
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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 shifts in the direction of a market. All four markets work together – some move with each other and some against.
Below, we'll cover how the four markets work together in cycles and how you can make those work for you. (For background reading, see: "Market Cycles: The Key to Maximum Returns" and "The Stock Cycle: What Goes Up Must Come Down.")
Intermarket Push and Pull of Commodities, Bonds, Stocks and Currencies
Let's first take a look at how commodities, bonds, stocks and currencies interact. As commodity prices rise, the cost of goods moves upward. This increasing price action is inflationary, and interest rates also rise to reflect the growing inflation. As a result, bond prices fall as interest rates rise since there is an inverse relationship between interest rates and bond prices.
Bond prices and stocks are generally correlated to one another. 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.
Currency has an impact on all markets, but the main one to focus on is commodity prices. Commodity prices also affect bonds and stocks, while 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 further reading, see "Commodity Prices and Currency Movements."
The table below shows the basic relationships of the currency, commodities, bond and stock 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. 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?
Intermarket Trading Across Commodities, Bonds, Stocks and Currencies
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 fall and stocks are still charging forward. These relationships will eventually overcome the bullishness in stocks, which will be forced to retreat at a certain point.
As mentioned, commodities rising and bonds starting to fall is not a sell signal 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 trend downward. There is no clear cut signal to sell stocks; in fact, there can still 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 Does Intermarket Analysis Break Down?
There are times when the relationships between commodities, bonds, stocks and currencies will seem to break down. For instance, during the Asian collapse of 1997, the U.S. markets saw stocks and bonds decouple. This violates the aforementioned 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 further insight, see "What Does Deflation Mean to Investors?")
Deflation is generally going to push the stock market down, as poor growth potential in stocks means that it is unlikely they will increase in value. Bond prices, on the other hand, will likely move higher to reflect falling interest rates (i.e., interest rates and bond prices move in opposite directions). Therefore, we must be aware of inflationary and deflationary environments in order to determine the resulting correlations between bonds and stocks.
Yet there are certain times where despite the economic environment, 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 a likely bearish indicator for bond and stock prices. The basic relationships still hold, even if one market is not moving because there are always multiple factors at work in the economy.
It's also important to take global factors into account. As companies become increasingly global, they play large roles in the direction of the U.S. markets. For instance, the stock market and currencies may take on an inverse relationship as companies continue to expand. This is because as companies conduct 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.
The Bottom Line
Intermarket analysis is a valuable tool when investors understand its use. However, we must be aware of the long-term economic environment (inflationary or deflationary) and adjust our analysis of intermarket relationships accordingly. Intermarket analysis should be used as just one of many tools to judge the direction of certain markets or whether a trend is likely to continue over time.