Mastering Intermarket Analysis: Understanding Market Relationships for Better Trading
How Understanding Market Relationships Can Enhance Your Trading Strategy
The Birth of Intermarket Analysis
Origin
Intermarket analysis is a technical analysis method pioneered by John J. Murphy. He introduced this concept through his seminal book “Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity and Currency Markets,” published in 1991, and further developed it in subsequent works like “Trading with Intermarket Analysis.”
Purpose
This method aims to analyze the relationships between different asset classes such as stocks, bonds, commodities, and currencies to identify trends and market strengths.
History of Development
Early 20th Century
In the early 20th century, financial markets operated independently with minimal interaction. However, significant economic events like the Great Depression of 1929 highlighted the interconnectedness of these markets as the global recession impacted all financial sectors.
Post-World War II
After World War II, globalization and the growth of international trade made financial markets more interconnected. Cross-border investments and the rise of investment funds increased the complexity and interaction between markets.
The 1980s
The information technology boom and the development of financial derivatives in the 1980s significantly strengthened the links between financial markets. Tools like correlation coefficients and automated trading systems became foundational to modern intermarket analysis.
What is Intermarket Analysis?
Intermarket analysis examines the correlations between various financial markets. By understanding how different asset classes influence each other, traders can gain insights into market trends and make more informed decisions. The four major groups in intermarket analysis are:
- Bond and Interest Rate Markets
- Commodity Markets
- Stock Markets
- Currency Markets
Why Intermarket Analysis Matters
Economic Cycles and Relationships Between Markets
The relationships between markets can shift over time and depend on the economic cycle. Especially, during financial crises, these relationships may break down or change significantly, highlighting the need for a flexible and adaptive approach.
- Stage I: Early Contraction
- Characteristics: The economy begins to slow down. Indicators such as industrial production, retail sales, and consumer spending start to decline. Unemployment may begin to rise, and interest rates often fall as central banks try to stimulate the economy.
- Investment Strategy: Buy bonds, as they tend to perform well with falling interest rates.
- Key Sectors: Utilities, food producers, U.S. Treasuries.
2. Stage II: Late Contraction
- Characteristics: The economy is in full contraction. GDP growth is negative, unemployment is high, and consumer confidence is low. Central banks may implement aggressive monetary policies to counteract the downturn.
- Investment Strategy: Buy stocks, as they are typically undervalued and poised for recovery.
- Key Sectors: Banks, technology, consumer discretionary.
3. Stage III: Early Expansion
- Characteristics: The economy starts to recover. Economic indicators such as GDP growth, industrial production, and consumer spending begin to improve. Unemployment decreases, and consumer confidence rises.
- Investment Strategy: Buy inflation-sensitive assets, as inflation may start to pick up.
- Key Sectors: Technology, transports, oil drillers.
4. Stage IV: Peak Expansion
- Characteristics: The economy is at its peak. Growth rates are high but may start to plateau. Inflationary pressures increase, leading to potential interest rate hikes by central banks.
- Investment Strategy: Sell bonds, as rising interest rates will negatively impact bond prices.
- Key Sectors: Oil drillers, diversified metals, energy.
5. Stage V: Late Expansion
- Characteristics: Economic growth begins to slow, but remains positive. Inflation may continue to rise, prompting further interest rate increases. Asset bubbles may form in certain markets.
- Investment Strategy: Sell stocks, as the risk of a market correction increases.
- Key Sectors: Diversified metals, healthcare.
6. Stage VI: Early Contraction
- Characteristics: The economy starts to slow significantly. Economic indicators turn negative, and growth rates decline. Central banks may begin to lower interest rates in response to slowing growth.
- Investment Strategy: Sell inflation-sensitive assets, as inflationary pressures decrease.
- Key Sectors: U.S. Treasuries.
Market relationships are influenced by different phases of the economic cycle (expansion, recession, trough, peak). Recognizing these phases helps traders anticipate market movements with greater accuracy.
Correlation Coefficient
The correlation coefficient measures the degree of relationship between two markets. It can be positive (moving together), negative (moving oppositely), or uncorrelated (random). This metric is essential for understanding how one market may influence another.
- USDX UP = Gold (Silver) DOWN
- USDX (DXY) and Gold (GOLD):
- Correlation: -0.98
- Explanation: Strong negative correlation supports the relationship. When USD Index goes up, Gold tends to go down.
2. GOLD UP = AUS & NZD UP
Gold (GOLD) and AUD/USD (AUDUSD):
- Correlation: 0.83
- Explanation: Positive correlation supports the relationship. When Gold prices go up, AUD/USD also tends to go up.
3. OIL UP = USDCAD DOWN
Oil (WTI) and USD/CAD (USDCAD):
- Correlation: -0.96
- Explanation: Strong negative correlation supports the relationship. When Oil prices go up, USD/CAD tends to go down.
4. DOW UP = Nikkei Index UP
- Dow Jones (DJI) and Nikkei Index (N225):
- Correlation: 0.92
- Explanation: Strong positive correlation supports the relationship. When the Dow Jones goes up, the Nikkei Index also tends to go up.
5. Nikkei Index DOWN = USDJPY DOWN
Nikkei Index (N225) and USD/JPY (USDJPY):
- Correlation: 0.78
- Explanation: Positive correlation contradicts the relationship stated as Nikkei Index DOWN should correlate with USD/JPY DOWN (negative correlation expected).
6. Yields DOWN = Currency DOWN
Yields (TNX) and EUR/USD (EURUSD):
- Correlation: 0.93
- Explanation: Positive correlation does not support the relationship. A negative correlation would indicate that when yields go down, currency also goes down.
7. Gold DOWN = USD/CAD UP
- Correlation: -0.90
- Explanation: Strong negative correlation supports the relationship. When Gold goes down, USD/CAD tends to go up.
8. SPX (S&P 500) UP = TNX UP = Bitcoin UP = DXY DOWN
BTCUSD vs. SPX (S&P 500): 0.99
- Explanation: The high correlation suggests that Bitcoin has been moving in tandem with the broader equity market, potentially due to institutional adoption and macroeconomic factors affecting both markets.
SPX vs. DXY (USD Index): -0.98
- Explanation: The S&P 500 tends to have an inverse relationship with the USD Index. A stronger dollar can negatively impact U.S. multinational companies’ earnings, leading to a weaker S&P 500.
SPX vs. TNX (10-Year Treasury Note): 0.77
- Explanation: Rising yields often indicate a strong economy, which can positively impact the stock market. However, higher yields can also increase borrowing costs for companies, creating a mixed relationship.
Tranding Strategies
Use Intermarket Correlations for Portfolio Diversification
One of the key benefits of intermarket analysis is its ability to inform portfolio diversification. By understanding how different markets interact, you can create a balanced portfolio that mitigates risk and maximizes returns:
- Diversify Across Asset Classes: Spread your investments across bonds, commodities, stocks, and currencies to reduce risk. If one market underperforms, gains in another can offset the losses.
- Hedge Against Market Movements: Use intermarket relationships to hedge positions. For example, if you have a significant investment in the stock market, consider investing in bonds or commodities as a hedge against potential downturns.
- Optimize Asset Allocation: Regularly adjust your portfolio based on changing correlations. If commodities are expected to rise due to falling bond prices, increase your allocation in commodities to take advantage of this trend.
Diversification based on intermarket analysis ensures that your portfolio is not overly exposed to the volatility of a single asset class.Illustrative Examples and Trading Strategies
Long-term Direction
Understanding these intermarket relationships can enhance your long-term trading strategies. Here’s how you can apply this knowledge:
ICT notes on Intermarket analysis — How to apply in Forex market
- Bullish Dollar Index: Anticipate bearish trends in gold and other commodities.
- Bullish Gold: Look for bullish trends in gold-exporting countries’ currencies (e.g., AUD, NZD).
- Bullish Oil: Expect bearish trends in USD/CAD due to Canada’s oil exports.
- Bullish Dow: A bullish Dow often leads to a bullish Nikkei index.
- Bearish Yields: Anticipate bearish trends in currencies as investors seek higher yields.
10 steps to apply it in Currency trading strategy. Source: author’s whimsical page
Key Indicators
- S&P 500, Dow Jones Industrial Average (DJI): Major US stock indices.
- U.S. 10-Year Treasury Yield (US10Y): Yield on the 10-year US Treasury bond.
- Crude Oil (WTI), Gold (XAU/USD): Prices of crude oil and gold.
- U.S. Dollar Index (DXY): Measures the value of the US dollar against a basket of major currencies.
Cheat Sheet
Conclusion
Intermarket analysis is a vital tool that helps investors and traders gain a deeper understanding of the relationships between different financial markets. By applying the principles and tools of intermarket analysis, traders can better predict market trends and manage risks effectively. This approach not only enhances the chances of trading success but also safeguards portfolios against unexpected market volatility.
Reference
- Intermarket analysis by Profressinal Training Academy
- Intermarket Analysis — What’s It, Example, Cheat Sheet, Importance (wallstreetmojo.com)
