TRADING STRATEGIES

FOR THE GLOBAL

STOCK, BOND, COMMODITY

AND CURRENCY MARKETS

John J. Murphy

Wiley Finance Editions

JOHN WILEY & SONS, INC.

New York • Chichester • Brisbane • Toronto • Singapore

In recognition of the importance of preserving what has

been written, it is a policy of John Wiley & Sons, Inc. to

have books of enduring value printed on acid-free paper,

and we exert our best efforts to that end.

Published by John Wiley & Sons, Inc.

All rights reserved. Published simultaneously in Canada.

Reproduction or translation of any part of this work

beyond that permitted by Section 107 or 108 of the

permission or further information should be addressed to

the Permissions Department, John Wiley & Sons, Inc.

This publication is designed to provide accurate and

authoritative information in regard to the subject

matter covered. It is sold with the understanding that

the publisher is not engaged in rendering legal, accounting,

Preface v

1 A New Dimension in Technical Analysis 1

2 The 1987 Crash Revisited—an Intermarket Perspective 12

3 Commodity Prices and Bonds 20

4 Bonds Versus Stocks 40

5 Commodities and the U.S. Dollar 56

6 The Dollar Versus Interest Rates and Stocks 74

7 Commodity Indexes 95

Preface

Like that of most technical analysts, my analytical work for many years relied on

traditional chart analysis supported by a host of internal technical indicators. About

five years ago, however, my technical work took a different direction. As consulting

editor for the Commodity Research Bureau (CRB), I spent a considerable amount of

time analyzing the Commodity Research Bureau Futures Price Index, which measures

the trend of commodity prices. I had always used the CRB Index in my analysis of

commodity markets in much the same way that equity analysts used the Dow Jones

Industrial Average in their analysis of common stocks. However, I began to notice

some interesting correlations with markets outside the commodity field, most notably

the bond market, that piqued my interest.

The simple observation that commodity prices and bond yields trend in the

same direction provided the initial insight that there was a lot more information to

be got from our price charts, and that insight opened the door to my intermarket

journey. As consultant to the New York Futures Exchange during the launching of

a futures contract on the CRB Futures Price Index, my work began to focus on the

relationship between commodities and stocks, since that exchange also trades a stock

index futures contract. I had access to correlation studies being done between the

various financial sectors: commodities, Treasury bonds, and stocks. The results of

for the stock market crash in the fall of that year. The interplay between the dollar, the

commodity markets, bonds, and stocks during 1987 convinced me that intermarket

analysis represented a critically important dimension to technical work that could

no longer be ignored.

• Another by-product of 1987 was my growing awareness of the importance of

international markets as global stock markets rose and fell together that year. I noticed

that activity in the global bond and stock markets often gave advance warnings of

what our markets were up to. Another illustration of global forces at work was given

at the start of 1990, when the collapse in the American bond market during the first

quarter was foreshadowed by declines in the German, British, and Japanese markets.

The collapse in the Japanese stock market during the first quarter of 1990 also gave

advance warning of the coming drop in other global equity markets, including our

own, later that summer.

This book is the result of my continuing research into the world of intermarket

analysis. I hope the charts that are included will clearly demonstrate the interrela-

tionships that exist among the various market sectors, and why its so important to be

aware of those relationships. I believe the greatest contribution made by intermarket

analysis is that it improves the technical analysts peripheral trading vision. Trying to

trade the markets without intermarket awareness is like trying to drive a car without

looking out the side and rear windows—in other words, its very dangerous.

The application of intermarket analysis extends into all markets everywhere on

the globe. By turning the focus of the technical analyst outward instead of inward,

intermarket analysis provides a more rational understanding of technical forces at

work in the marketplace. It provides a more unified view of global market behavior.

Intermarket analysis uses activity in surrounding markets in much the same way

that most of us have employed traditional technical indicators, that is, for directional

clues. Intermarket analysis doesnt replace other technical work, but simply adds

another dimension to it. It also has some bearing on interest rate direction, inflation,

Federal Reserve policy, economic analysis, and the business cycle.

in Technical Analysis

One of the most striking lessons of the 1980s is that all markets are interrelated—

financial and nonfinancial, domestic and international. The U.S. stock market doesnt

trade in a vacuum; it is heavily influenced by the bond market. Bond prices are very

much affected by the direction of commodity markets, which in turn depend on the

trend of the U.S. dollar. Overseas markets are also impacted by and in turn have

an impact on the U.S. markets. Events of the past decade have made it clear that

markets dont move in isolation. As a result, the concept of technical analysis is

now evolving to take these intermarket relationships into consideration. Intermarket

technical analysis refers to the application of technical analysis to these intermarket

linkages.

The idea behind intermarket analysis seems so obvious that its a mystery why we

havent paid more attention to it sooner. Its not unusual these days to open a financial

newspaper to the stock market page only to read about bond prices and the dollar. The

bond page often talks about such things as the price of gold and oil, or sometimes

even the amount of rain in Iowa and its impact on soybean prices. Reference is

frequently made to the Japanese and British markets. The financial markets havent

really changed, but our perception of them has.

Think back to 1987 when the stock market took its terrible plunge. Remember

how all the other world equity markets plunged as well. Remember how those same

world markets, led by the Japanese stock market, then led the United States out of

those 1987 doldrums to record highs in 1989 (see Figure 1.1).

A NEW DIMENSION IN TECHNICAL ANALYSIS

FIGURE 1.1

A COMPARISON Of THE WORLDS THREE LARGEST EQUITY MARKETS: THE UNITED STATES,

JAPAN, AND BRITAIN. GLOBAL MARKETS COLLAPSED TOGETHER IN 1987. THE SUBSEQUENT

GLOBAL STOCK MARKET RECOVERY THAT LASTED THROUGH THE END OF 1989 WAS LED BY

THE JAPANESE MARKET.

World Equity Trends

Reproduced with permisson by Knight Bidders Tradecenter. Tradecenter is a registered trademark of Knight Ridders Financial Information.

ALL MARKETS ARE RELATED

What this means for us as traders and investors is that it is no longer possible to

study any financial market in isolation, whether its the U.S. stock market or gold

futures. Stock traders have to watch the bond market. Bond traders have to watch

the commodity markets. And everyone has to watch the U.S. dollar. Then theres the

Japanese stock market to consider. So who needs intermarket analysis? I guess just

about everyone; since all sectors are influenced in some way, it stands to reason that

anyone interested in any of the financial markets should benefit in some way from

knowledge of how intermarket relationships work.

IMPLICATIONS FOR TECHNICAL ANALYSIS

Technical analysis has always had an inward focus. Emphasis was placed on a par-

ticular market to which a host of internal technical indicators were applied. There

THE PURPOSE OF THIS BOOK 3

was a time when stock traders didnt watch bond prices too closely, when bond

traders didnt pay too much attention to commodities. Study of the dollar was left to

interbank traders and multinational corporations. Overseas markets were something

we knew existed, but didnt care too much about.

It was enough for the technical analyst to study only the market in question. To

consider outside influences seemed like heresy. To look at what the other markets

were doing smacked of fundamental or economic analysis. All of that is now

changing. Intermarket analysis is a step in another direction. It uses information in

related markets in much the same way that traditional technical indicators have been

employed. Stock technicians talk about the divergence between bonds and stocks in

much the same way that they used to talk about divergence between stocks and the

advance/decline line.

Markets provide us with an enormous amount of information. Bonds tell us

which way interest rates are heading, a trend that influences stock prices. Commodity

prices tell us which way inflation is headed, which influences bond prices and

interest rates. The U.S. dollar largely determines the inflationary environment and

influences which way commodities trend. Overseas equity markets often provide

valuable clues to the type of environment the U.S. market is a part of. The job of

the technical trader is to sniff out clues wherever they may lie. If they lie in another

market, so be it. As long as price movements can be studied on price charts, and as

long as it can be demonstrated that they have an impact on one another, why not

take whatever useful information the markets are offering us? Technical analysis is

the study of market action. No one ever said that we had to limit that study to only

the market or markets were trading.

Intermarket analysis represents an evolutionary step in technical analysis.

Intermarket work builds on existing technical theory and adds another step to

the analytical process. Later in this chapter, Ill discuss why technical analysis

is uniquely suited to this type of investigative work and why technical analysis

represents the preferred vehicle for intermarket analysis.

THE PURPOSE OF THIS BOOK

The goal of this book is to demonstrate how these intermarket relationships work in a

way that can be easily recognized by technicians and nontechnicians alike. You wont

have to be a technical expert to understand the argument, although some knowledge

of technical analysis wouldnt hurt. For those who are new to technical work, some of

the principles and tools employed throughout the book are explained in the Glossary.

However, the primary focus here is to study interrelationships between markets, not

to break any new ground in the use of traditional technical indicators.

Well be looking at the four market sectors—currencies, commodities, bonds,

and stocks—as well as the overseas markets. This is a book about the study of market

action. Therefore, it will be a very visual book. The charts should largely speak for

themselves. Once the basic relationships are described, charts will be employed to

show how they have worked in real life.

Although economic forces, which are impossible to avoid, are at work here, the

discussions of those economic forces will be kept to a minimum. Its not possible to

do intermarket work without gaining a better understanding of the fundamental forces

behind those moves. However, our intention will be to stick to market action and keep

economic analysis to a minimum. We will devote one chapter to a brief discussion

4 A NEW DIMENSION IN TECHNICAL ANALYSIS

of the role of intermarket analysis in the business cycle, however, to provide a useful

chronological framework to the interaction between commodities, bonds, and stocks.

FOUR MARKET SECTORS: CURRENCIES,

COMMODITIES, BONDS, AND STOCKS

The key to intermarket work lies in dividing the financial markets into these four

sectors. How these four sectors interact with each other will be shown by various vi-

BASIC PREMISES OF INTERMARKET WORK 5

widely watched gauge of commodity price direction. Other commodity indexes will

be discussed as well.

The strong inverse relationship between the CRB Index and bond prices will be

shown. Events of 1987 and thereafter take on a whole new light when activity in the

CRB Index is factored into the financial equation. Comparisons between bonds and

stocks will be used to show that bond prices provide a useful confirming indicator

and often lead stock prices.

I hope youll begin to see that if youre not watching these relationships, youre

missing vital market information (see Figure 1.2).

Youll also see that very often stock market moves are the end result of a ripple

effect that flows through the other three sectors—a phenomenon that carries important

implications in the area of program trading. Among the financial media and those

who havent acquired intermarket awareness, program trading is often unfairly

blamed for stock market drops without any consideration of what caused the program

trading in the first place. Well deal with the controversial subject of program trading

in Chapter 14.

BASIC PREMISES OF INTERMARKET WORK

Before we begin to study the individual relationships, Id like to lay down some basic

premises or guidelines that Ill be using throughout the book. This should provide a

useful framework and, at the same time, help point out the direction well be going.

Then Ill briefly outline the specific relationships well be focusing on. There are

an infinite number of relationships that exist between markets, but our discussions

will be limited to those that I have found most useful and that I believe carry the

most significance. After completion of the overview contained in this chapter, well

proceed in Chapter 2 to the events of 1987 and begin to approach the material in

more specific fashion. These, then, are our basic guidelines:

1. All markets are interrelated; markets dont move in isolation.

2. Intermarket work provides important background data.

3. Intermarket work uses external, as opposed to internal, data.

4. Technical analysis is the preferred vehicle.

5. Heavy emphasis is placed on the futures markets.

6. Futures-oriented technical indicators are employed.

These premises form the basis for intermarket analysis. If it can be shown that all

markets—financial and nonfinancial, domestic and global—are interrelated, and that

all are just part of a greater whole, then it becomes clear that focusing ones attention

Bonds

6 A NEW DIMENSION IN TECHNICAL ANALYSIS

INTERMARKET ANALYSIS AS BACKGROUND INFORMATION

The key word here is background. Intermarket work provides background

information, not primary information. Traditional technical analysis still has to be

applied to the markets on an individual basis, with primary emphasis placed on the

market being traded. Once thats done, however, the next step is to take intermarket

relationships into consideration to see if the individual conclusions make sense from

an intermarket perspective.

Suppose intermarket work suggests that two markets usually trend in opposite

directions, such as Treasury bonds and the Commodity Research Bureau Index.

Suppose further that a separate analysis of the top markets provides a bullish outlook

for both at the same time. Since those two conclusions, arrived at by separate analysis,

contradict their usual inverse relationship, the analyst might want to go back and

reexamine the individual conclusions.

There will be times when the usual intermarket relationships arent visible or,

for a variety of reasons, appear to be temporarily out of line. What is the trader to do

when traditional technical analysis clashes with intermarket analysis? At such times,

traditional analysis still takes precedence but with increased caution. The trader who

gets bullish readings in two markets that usually dont trend in the same direction

knows one of the markets is probably giving false readings, but isnt sure which one.

The prudent course at such times is to fall back on ones separate technical work, but

to do so very cautiously until the intermarket work becomes clearer.

Another way to look at it is that intermarket analysis warns traders when they

can afford to be more aggressive and when they should be more cautious. They may

remain faithful to the more traditional technical work, but intermarket relationships

may. serve to warn them not to trust completely what the individual charts are

showing. There may be other times when intermarket analysis may cause a trader

to override individual market conclusions. Remember that intermarket analysis is

meant to add to the traders data, not to replace what has gone before. Ill try to

resolve this seeming contradiction as we work our way through the various examples

in succeeding chapters.

EXTERNAL RATHER THAN INTERNAL DATA

Traditional technical work has tended to focus its attention on an individual market,

such as the stock market or the gold market. All the market data needed to analyze

an individual market technically—price, volume, open interest—was provided by

the market itself. As many as 40 different technical indicators—on balance volume,

moving averages, oscillators, trendlines, and so on—were applied to the market along

with various analytical techniques, such as Elliott Wave theory and cycles. The goal

was to analyze the market separately from everything else.

Intermarket analysis has a totally different focus. It suggests that important

directional clues can be found in related markets. Intermarket work has a more

outward focus and represents a different emphasis and direction in technical work.

One of the great advantages of technical analysis is that it is very transferable.

A technician doesnt have to be an expert in a given market to be able to analyze

it technically. If a market is reasonably liquid, and can be plotted on a chart, a

technical analyst can do a pretty adequate job of analyzing it. Since intermarket

analysis requires the analyst to look at so many different markets, it should be obvious

why the technical analyst is at such an advantage.

EMPHASIS ON THE FUTURES MARKETS 7

Technicians dont have to be experts in the stock market, bond market, currency

market, commodity market, or the Japanese stock market to study their trends

and their technical condition. They can arrive at technical conclusions and make

intermarket comparisons without understanding the fundamentals of each individual

market. Fundamental analysts, by comparison, would have to become familiar with

all the economic forces that drive each of these markets individually—a formidable

task that is probably impossible. It is mainly for this reason that technical analysis

is the preferred vehicle for intermarket work.

EMPHASIS ON THE FUTURES MARKETS

Intermarket awareness parallels the development of the futures industry. The main

reason that we are now aware of intermarket relationships is that price data is now

readily available through the various futures markets that wasnt available just 15 years

ago. The price discovery mechanism of the futures markets has provided the catalyst

that has sparked the growing interest in and awareness of the interrelationships among

the various financial sectors.

In the 1970s the New York commodity exchanges expanded their list of

traditional commodity contracts to include inflation-sensitive markets such as

gold and energy futures. In 1972 the Chicago Mercantile Exchange pioneered the

development of the first financial futures contracts on foreign currencies. Starting in

1976 the Chicago exchanges introduced a new breed of financial futures contracts

covering Treasury bonds and Treasury bills. Later on, other interest rate futures, such

as Eurodollars and Treasury notes, were added. In 1982 stock index futures were

introduced. In the mid-1980s in New York, the Commodity Research Bureau Futures

Price Index and the U.S. Dollar Index were listed.

Prior to 1972 stock traders followed only stocks, bond traders only bonds,

currency traders only currencies, and commodity traders only commodities. After

1986, however, traders could pick up a chart book to include graphs on virtually

every market and sector. They could see right before their eyes the daily movements

in the various futures markets, including agricultural commodities, copper, gold, oil,

the CRB Index, the U.S. dollar, foreign currencies, bond, and stock index futures.

Traders in brokerage firms and banks could now follow on their video screens the

minute-by-minute quotes and chart action in the four major sectors: commodities,

currencies, bonds, and stock index futures. It didnt take long for them to notice that

these four sectors, which used to be looked at separately, actually fed off one another.

A whole new way to look at the markets began to evolve.

On an international level, stock index futures were introduced on various

overseas equities, in particular the British and Japanese stock markets. As various

financial futures contracts began to proliferate around the globe, the world suddenly

seemed to grow smaller. In no small way, then, our ability to monitor such a broad

range of markets and our increased awareness of how they interact derive from the

development of the various futures markets over the past 15 years.

It should come as no surprise, then, that the main emphasis in this book will be

on the futures markets. Since the futures markets cover every financial sector, they

provide a useful framework for our intermarket work. Of course, when we talk about

stock index futures and bond futures, were also talking about the stock market and

the Treasury bond market as well. Were simply using the futures markets as proxies

for all of the sectors under study.

8 A NEW DIMENSION IN TECHNICAL ANALYSIS

Since most of our attention will be focused on the futures markets, Ill

be employing technical indicators that are used primarily in the futures markets.

There is an enormous amount of overlap between technical analysis of stocks and

futures, but there are certain types of indicators that are more heavily used in each

area.

For one thing, Ill be using mostly price-based indicators. Readers familiar with

traditional technical analysis such as price pattern analysis, trendlines, support and

resistance, moving averages, and oscillators should have no trouble at all.

Those readers who have studied my previous book, Technical Analysis of the

Futures Markets (New York Institute of Finance/Prentice-Hall, 1986) are already well

prepared. For those newer to technical analysis, the Glossary gives a brief introduction

to some of the work we will be employing. However, Id like to stress that while

some technical work will be employed, it will be on a very basic level and is not

the primary i focus. Most of the charts employed will be overlay, or comparison,

charts that simply compare the price activity between two or three markets. You

should be able to see these relationships even with little or no knowledge of tech-

Finally, one other advantage of the price-based type of indicators widely used in

the futures markets is that they make comparison with related markets, particularly

overseas markets, much easier. Stock market work, as it is practiced in the United

States, is very heavily oriented to the use of sentiment indicators, such as the degree

of bullishness among trading advisors, mutual fund cash levels, and put/call ratios.

Since many of the markets we will be looking at do not provide the type of data needed

to determine sentiment readings, the price-oriented indicators I will be employing

lend themselves more readily to intermarket and overseas comparisons.

THE IMPORTANT ROLE

OF THE COMMODITY MARKETS

Although our primary goal is to examine intermarket relationships between financial

sectors, a lot of emphasis will be placed on the commodity markets. This is done

for two reasons. First, well be using the commodity markets to demonstrate how

relationships within one sector can be used as trading information. This should

prove especially helpful to those who actually trade the commodity markets. The

second, and more important, reason is based on my belief that commodity markets

represent the least understood of the market sectors that make up the intermarket

chain. For reasons that well explain later, the introduction of a futures contract on

the CRB Index in mid-1986 put the final piece of the intermarket structure in place

and helped launch the movement toward intermarket awareness.

The key to understanding the intermarket scenario lies in recognizing the often

overlooked role that the commodity markets play. Those readers who are more

involved with the financial markets, and who have not paid much attention to

the commodity markets, need to learn more about that area. Ill spend some time,

therefore, talking about relationships within the commodity markets themselves, and

then place the commodity group as a whole into the intermarket structure. To perform

the latter task, Ill be employing various commodity indexes, such as the CRB Index.

1. Action within commodity groups, such as the relationship of gold to platinum

or crude to heating oil.

2. Action between related commodity groups, such as that between the precious

metals and energy markets.

3. The relationship between the CRB Index and the various commodity groups and

markets.

4. The inverse relationship between commodities and bonds.

5. The positive relationship between bonds and the stock market.

6. The inverse relationship between the U.S. dollar and the various commodity

markets, in particular the gold market.

7. The relationship between various futures markets and related stock market

groups, for example, gold versus gold mining shares.

8. U.S. bonds and stocks versus overseas bond and stock markets.

THE STRUCTURE OF THIS BOOK

This chapter introduces the concept of intermarket technical analysis and provides

a general foundation for the more specific work to follow. In Chapter 2, the events

leading up to the 1987 stock market crash are used as the vehicle for providing an

intermarket overview of the relationships between the four market sectors. Ill show

how the activity in the commodity and bond markets gave ample warning that the

strength in the stock market going into the fall of that year was on very shaky ground.

hi Chapter 3 the crucial link between the CRB Index and the bond market, which is

the most important relationship in the intermarket picture, will be examined in more

depth. The real breakthrough in intermarket work comes with the recognition of how

commodity markets and bond prices are linked (see Figure 1.3).

Chapter 4 presents the positive relationship between bonds and stocks. More and

more, stock market analysts are beginning to use bond price activity as an important

indication of stock market strength. The link between commodities and the U.S. dollar

will be treated in Chapter 5. Understanding how movements in the U.S. dollar affect

the general commodity price level is helpful in understanding why a rising dollar

is considered bearish for commodity markets and generally positive for bonds and

stocks. In Chapter 6 the activity in the U.S. dollar will then be compared to interest

rate futures.

Chapter 7 will delve into the world of commodities. Various commodity indexes

will be compared for their predictive value and for their respective roles in influencing

the direction of inflation and interest rates. The CRB Index will be examined closely,

as will various commodity subindexes. Other popular commodity gauges, such as

the Journal of Commerce and the Raw Industrial Indexes, will be studied. The

relationship of commodity markets to the Producer Price Index and the Consumer

Price Index will be treated along with an explanation of how the Federal Reserve

Board uses commodity markets in its policy making.

10 A NEW DIMENSION IN TECHNICAL ANALYSIS

FIGURE 1.3

BONDS AND COMMODITIES USUALLY TREND IN OPPOSITE DIRECTIONS. THAT INVERSE

RELATIONSHIP CAN BE SEEN DURING 1989 BETWEEN TREASURY BOND FUTURES AND THE

CRB FUTURES PRICE INDEX.

Bonds versus CRB Index

International markets will be discussed in Chapter 8, where comparisons will

be made between the U.S. markets and those of the other two world leaders, Britain

and Japan. Youll see why knowing whats happening overseas may prove beneficial

to your investing results. Chapter 9 will look at intermarket relationships from a

The Dow Jones Utility Average is recognized as a leading indicator of the stock

market. The Utilities are very sensitive to interest rate direction and hence the action

in the bond market. Chapter 10 is devoted to consideration of how the relationship

between bonds and commodities influence the Utility Average and the impact of that

average on the stock market as a whole. Ill show in Chapter 11 how relative strength,

or ratio analysis, can be used as an additional method of comparison between markets

and sectors.

THE STRUCTURE OF THIS BOOK 11

Chapter 12 discusses how ratio analysis can be employed in the asset allocation

process and also makes the case for treating commodity markets as an asset class