— Tips on Technicals — Intermarket Analysis

By Michael N. Kahn

Globally, all markets are connected in that stocks are led by bonds that are themselves led by interest rates. Rates are determined by the economy which takes its cue from raw materials prices. While technical analysis of any individual market can stand on its own, intermarket analysis can add another dimension to the process.

In his 1989 book, The Intermarket Technician, John J. Murphy made several key observations. He said that all markets are interrelated and that intermarket analysis borders on economic analysis. This is because traditionally non-technical terms, such as inflation and raw materials, are used. He also noted that the word domestic is largely irrelevant. This is evidenced in the shocks that frequently occur in global equities and even in the very existence of foreign exchange.

The Major Markets

Let’s take a look at some of the more common intermarket relationships followed today. Figure 1 shows the US stock and bond markets leading into the crash of 1987. In the beginning of the chart, the two markets moved up and down together. Note that the bond trend was broken a few weeks before the stock trend in March. Bonds also led the stock breakout to the upside in June.

In July, bonds began to fall again but this time stocks did not. The farther the two markets diverged, the more violent the eventual correction would have to be. On the day of the crash not only did stocks plummet but the bond market skyrocketed sending interest rates much lower. Both sides of the equation corrected dramatically.

Figure 1 and Figure 2

Traditionally, the Commodities Research Bureau (CRB) Index has been used to gauge inflation and hence analyze the bond market. Logically, if raw materials prices were rising, inflation would be at hand and interest rates would also rise. However, this link seemed to have been broken in late 1995 (figure 2). While the dynamics of the global economy may have changed that year, the relationship between the CRB index and interest rates did not. In 1996, the two resumed their closely tied movements.

Figure 3 shows the US Dollar Index against 30-year US bond yields and a clear correlation. Figure 4 shows two years of the US Dollar Index and the CRB Index and a clear inverse relationship between the two. The divergence between the CRB Index and interest rates in late 1995 is easily explained by the counter-trend move made by the dollar during the same period. These two relationships help explain why the CRB-bond relationship was unusual during that time.

Figure 3 and Figure 4

Intramarket Relationships

Intermarket analysis is also applied to similar markets. For example, a spread between oats and corn can be used to take advantage of two commodities with some degree of substitutability.

There are times when the market for a specific commodity becomes relatively illiquid and hedging a position is difficult. Canadian cash bond holders often use US bond futures to hedge due to the lack of liquidity in the Canadian bond futures markets.

Finally, analysis of components of an index falls under the intermarket umbrella. The commodities that make up the CRB Index can be individually correlated. Relative strength analysis can determine which commodities are leading and which are lagging. The same is true in the stock market where industry groups are compared to the major averages. On a micro level, individual stocks are compared to their own industries.

To tie it all together in a real world example, the analysis of a stock, such as chocolate maker Hershey Foods, should include the overall market, its major raw material cocoa, interest rates used to finance operations and debt, and foreign exchange rates used when calculating profits overseas. Any one of these markets affects the shareholders’ bottom line.

Michael N. Kahn is a columnist for Barron’s Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn’s Tips on Technicals is available in Real World Technical Analysis .