Inter-Market Analysis

[Submitted by Mr. Bhavik Bipin Mehta,
B.Com., CA and CS student,
Mumbai, Maharashtra]

June 14, 2008

I. Introduction:

Most traders stress the role of fundamental information and historical single-market price data in analyzing markets for the purpose of price and trend forecasting. For greater part of the past century, technical analysis was primarily based on Single market analysis.

Traders need to look forward to anticipate what will happen to prices if their analysis is to pay off in the real trading world. To be able to look ahead with confidence, however, traders need to look in one other direction, and that is sideways to what is happening in related markets, which has a major influence on price action in a target market. Over the past decade, emphasis in the technical world has shifted away from single-market work to a more Inter-market approach.

Because of globalization, Indian markets have merged/blended with the global markets. Now, economists are betting on the recoupling theory rather than decoupling. It is difficult to say that our markets are not correlated with the foreign markets.

Indian Chartered Accountants have penetrated into every stream of business and are an active and an important part of the International economic system. Therefore, I felt the need to explain this concept of Inter-market analysis.

II. Concept of Inter-Market Analysis:

Single-market analysis is the study of one asset class or market in a single country. Inter-market analysis, on the other hand, is the study of multiple asset classes in a variety of markets in nations around the globe. Those, who fail to do so, run the risk of seeing only a part of inter-market picture.

Intuitively, traders know that markets are interrelated and that a development that affects one market is likely to have repercussions in other markets. No market is isolated in today's global financial system. It is increasingly important that you factor into your analysis the external intermarket forces that influence each market being traded.

Ripple effect through all markets is sort of a circular cause-and-effect dynamic involving inflationary expectations, changes in interest rates, corporate earnings growth rates, stock prices, forex fluctuations. You can hardly name a market that isn't affected by other markets or, in turn, doesn't affect other markets. Whatever the market, assets tend to migrate toward the one producing or promising the highest return. You have probably heard the expression, "If the U.S. economy sneezes, the rest of the world catches cold" or that the health of the U.S. economy is the engine that drives the global economy. It works both ways as a sneeze elsewhere in the world can have a significant impact on U.S. markets, as was evident in the Asian financial crisis in 1997 and other incidences over the years that have provided proof, if any was still needed, of how linked today's global markets are.

III. Understanding of the Inter-Market Analysis:

The basic premise of Inter-Market Analysis is that all markets are related. What happens in one market has an effect on the other. On a macro level, four inter-related markets are:

  1. Currencies.
  2. Commodities.
  3. Bonds.
  4. Stocks.

A falling currency increases the prices of commodities in that country. The rise in prices of commodities awakens inflation fears and monetary authorities try to curb the inflation by increasing the interest rates. Due to increase in the interest rates, companies will now have to pay more interest on their loans which leads to lower profitability. Traders, investors and analysts will now start discounting the stocks affected by rising interest rates and lower profitability. The falling stock prices will discourage the foreign investors of entering these markets and will remove their money from the country. The exodus of foreign money will further depreciate the currency. Thus, we see that we have come a full u-turn i.e. back to square one. This is the concept of inter-market analysis. The concept is better explained with the help of following flow-chart diagram.

 

Falling Currency => Rising Commodity prices => Rising Inflation => Rising Interest Rates => Falling Stocks (not all) and Rising Bond Yield and Falling Bonds prices => Falling Currency

 

Thus, we understand that inter-market analysis plays a crucial role in global market. Downturn in currencies, rising commodity prices, rising interest rates can have a ripple effect and lead to global rotation of out of stocks into bonds.

The reverse is also true. A rising currency decreases the prices of commodities in that country. The fall in prices of commodities reduces inflation and monetary authorities decrease the interest rates. Due to decrease in the interest rates, companies will now have to pay less interest on their loans which leads to higher profitability. Traders, investors and analysts will now start discounting the stocks by lower interest rates and more profitability. The rising stock prices will encourage the foreign investors for entering these markets and will flush more money into the country. The entry of fresh foreign money will further appreciate the currency.

 

Appreciating Currency => Falling Commodity prices => Lower Inflation => Low Interest Rates => Rising Stocks (not all) and Falling Bond Yield and Rising Bonds prices => Appreciating Currency

 

Let us review the key relationships involved in intermarket analysis:

  1. Commodity prices and bond prices trend in opposite direction. Commodity prices and bond yields usually trend in same direction.
  2. Bond prices trend in same direction as stock market.
  3. Rising bond prices are good for stocks. Falling bond yields are good for stocks.
  4. Bond market changes direction long before stocks do; therefore the bond market is a leading indicator of potential trend changes in stocks.
  5. Commodity prices trend in opposite direction of currency.
  6. A rising currency is good for stocks and bonds because it is non-inflationary.
  7. A strong currency attracts foreign money into stock market.

IV Advantages:

Intermarket analysis can also teach us the important historic relationship bonds, stocks and commodities in the business cycle. Bond prices generally lead stock prices in a recovery, with commodity prices confirming that a period of economic expansion has begun. As the expansion matures and begins to slow down, intermarket analysis teaches traders to watch for bonds to turn down first (as interest rates rise), followed by stocks. Finally, when commodity prices turn down, there is a pretty good chance that economic expansion has come to an end. The next phase is a slowdown and possible recession.

For example: Rising commodity prices contributed to higher global inflation and higher interest rates. U.S. Economists spent most of the 1999 questioning the rise in the U.S. interest rates in the face of relatively low U.S. inflation. What they may have failed to recognize is that the upturn in U.S. interest rates may have had more to do with strength in the Japanese economy than the U.S. economy.

Financial experts sing the praises of the diversified portfolio. "It is never a good idea to put all your eggs in one basket," they say. What they mean is that limiting your investments to just a few companies greatly increases your risk, especially if one or two of your major holdings experience a meltdown.

A truly diversified investment approach should include investments in all four major asset classes: stocks, bonds, currencies and commodities. Going one step further, intermarket analysis tells us that a truly diversified portfolio should not limit its holdings to one country, but include holdings in a number of markets around the world. By following multiple markets, an investor gets the big picture and is able to see significant market and economic changes earlier than investors with a single market focus. The multiple-market investor can then move portfolio holdings from one sector or market to another - a practice known as sector rotation - with greater ease as conditions change.

V. Analytical challenge:

Intermarket analysis is not an easy task to accomplish for the average trader. Money tends to flow from one sector to another or one industry to another. The complexity of the dynamics between markets and their influences on each other mean that just comparing price charts of two markets and producing a chart of the spread difference or a ratio between the two prices is not enough to get the full picture of strength or weakness or its potential for a price move.

Some analysts like to do correlation studies of two related markets, which measures the degree to which the prices of one market move in relation to the prices of the second market. Two markets are considered perfectly correlated if the price change of the second market can be forecasted precisely from the price change of the first market. A perfectly positive correlation occurs when both markets move in the same direction. A perfectly negative correlation occurs when the two markets move in opposite directions.

But this approach has its limitations because it compares prices of only two markets to one another and does not take into account the influence exerted by other markets or other markets on the target market. In the financial markets, a number of related markets need to be included in the analysis rather than assuming that there is a one-to-one cause-effect relationship between just two markets.

Nor do the correlations study takes into account the leads and lags that may exist in economic activity or other factors affecting a market. Typically their calculations are based only on the values at the moment and may not consider the longer-term consequences of central bank intervention or a policy change that takes some time to play itself out in the markets.