The market can be an overwhelming place for an eager investor. The multiple indexes, stock types and categories can be confusing, and the intermarket relationships of different sectors can be tough to understand. However, learning how the interaction goes between different markets can make the picture a lot clearer. Mastering the relationships between commodities, bond prices, stocks and currencies, can make the investor become the best in trading.
These four markets work together. Some move together, while others work against each other. Most of the time, the cycle moves in a general order. What we need to do is to observe all four markets in able to determine the direction of where the shift is heading. Here we will reveal how this cycle moves, and how you can make it work for you.
The Intermarket push and pull
Let’s begin with the interaction between commodities, bonds, stocks and currencies. The price of goods increase, as the commodity price rises. This action of price growth is inflationary, which comes with the rise of interest rates as its reflection. Due to the inverse relationship of interest rates and bond prices, bond prices fall as interest rates increase.
Generally, bond prices correlate with stocks; vice versa. Meaning, when bond prices fall, stocks come with them, and head down as well. When the amount of borrowing becomes more expensive, building of businesses can be costlier due to inflation, which may lead to companies (stocks) to not do as well. Such events may result in lags between bond prices falling, and the decline of the stock market.
The movement of currency can affect all markets, but the main focus lies on the commodity prices. Commodity prices land an impact to bonds, and eventually stocks. The commodity prices and the US dollars generally trend in the opposite direction. The reaction of the dollar decline in relation to currency can be seen in the commodity prices.
Below is a table showing the basic intermarket relationships. Read the table from left to right, where the starting point can be anywhere in the row. The outcome of that move will be reflected in the market action to the right.
Not everything happens at once, due to lag in responses between each of the markets’ reactions. In between the lag, other factors could come into play.
Perhaps you’re asking: if there are many lags and the markets that should be moving inversely begin moving in the same direction, how can you, as an investor, take advantage?
Intermarket analysis can be an excellent tool for confirming trends, and can also warn you of potential reversals. However, you must keep in mind that it’s not a method that will give you signals for buying or selling. Because commodity prices rise in inflationary environments, it’s just a matter of time until the dampening effect will be felt in the economy. If commodities start to increase, and the bond prices begin to lower, stocks are still charging higher. The relationships among these factors will eventually overcome bullishness in stocks. It’s only a matter of when for stocks to start pulling back.
When selling stocks, remember that commodities rising and bonds decreasing don’t mean it’s time to trade. This circumstance can only serve as a warning that a probable reversal may happen anytime; perhaps in the coming months or year if the prices of bond continue to fall. During that time, there could be excellent financial gains in the bull market.
The most important aspect to keep track is when the stocks break below a moving average (MA) after bond prices have already started to fall. It’s a confirmation that the intermarket relationships are taking over and stocks are now going the opposite direction.
When does the cycle not work?
Although, we have established the relationships between markets, there are times that they don’t work, and seem to break down. In the middle of the Asian collapse of 1997, the U.S. markets witnessed stocks and bonds decouple, where stocks fell as bonds rose, and stocks rose as bonds fell. Meaning, it violated the intermarket relationship of positive correlation between bond and stock prices. It happened because unlike the typical market relationships that assume an inflationary economic environment, in a deflationary environment particular relationships will shift.
Generally, deflation pulls the stocks lower. In the absence of potential stock market growth, the stocks will less likely rise. On the other hand, bond prices will continue to grow to reflect falling interest rates. Thus, we must be aware of what economy we are in, to identify whether the bonds and stocks correlate each other positively or negatively.
There are also times when none of the markets seem to move. In those circumstances, it doesn’t mean that the other rules don’t apply. For instance, if the commodity prices have become stagnant, but the US dollar starts to fall, bond and stock prices may still appear bearish. There are always numerous factors that come into play in the economy. Therefore, basic relationships still work, despite some pieces of the puzzle are not moving.
Additionally, as the companies expand and become global, it can affect the stock’s movement. Over time, as companies grow, the relationship of the stock market and currencies may become inversely related. For an effective application of the intermarket analysis, we must understand the shifting dynamics of global economies when deviations are seen in asset class relationships.
This video delves deeper into the inner workings of different sectors of the economy and their impacts on one another :