Intermarket Analysis - Part 2
 
Hi everyone, in my last posting, we did an analysis on price movements across four financial markets - currencies, commodities, bonds and stocks. How they interact would give rise to their predictive value.

John Murphy, a pioneer in intermarket studies, made the following observations:

1. US dollar trends in opposite direction of commodities (as commodities are denominated in USD)
2. Commodities trend in opposite direction of bond prices (inflationary signal)
3. Commodities trend in same direction as interest rates (inflationary signal)
4. Falling rates are normally good for stocks (search for higher yields)
5. Bonds and stocks generally move in same direction (interest rate driven)
6. Bond market, however, normally changes direction ahead of stocks
7. A rising dollar is good for US stocks and bonds

If you study the charts I appended in my last few postings, you will notice there are some points of divergence worth highlighting here:

1. While commodities generally trend in opposite direction to the US dollar, it has not always been the case. An overriding factor is global growth outlook expectations which impact on demand for commodities. So while the US dollar may weaken given a weak domestic economy and aggressive monetary expansion, commodity prices did not rise much further especially if economies like China slow.

2. Current low interest rates did push up bond prices. But because there are little inflationary fears at the moment, commodities are not being bidded up.

3. Current low interest rates actually make equity investing more attractive because of the higher earnings yield and dividend payout from stocks, providing a good reason to participate in equity investing as institutional funds seek out higher yields.

4. Bonds and stocks are both on an uptrend since 2009. However, when looking at short-term swings, bonds and stocks have been moving in opposite directions. When stock prices are moving higher, bond prices would fall as interest rate rises, possibly to maintain some near-term yield parity across the two asset classes.

5. On the contrary, a stronger US dollar has not been that kind to the stock market. This could be due to the US dollar carry trade where US dollar was shorted by big players with the proceeds used to buy into US equities. When the US dollar rally, short-covering occurs and US equities had to be sold to raise funds to buy back the US dollar.

6. Bond prices are likely to lead in major stock market reversals so this will also be a key space to watch.

Meanwhile, the market has swung into a new up-leg, which may extend all the way till year-end. Notice how the asset classes continue to move in a similar fashion like they did during the previous up swings (see my earlier postings). Precious metals are trending strongly along with equities. (click or tab chart to enlarge)

Conclusion

Understanding inter-market analysis is key to improving our ability to forecast the markets. While classical economic and financial theories hold up well most times, for the shorter-term, it would be important to understand the prevailing sentiments driving the markets. For instance, expectations on growth outlook,  deflationary concerns (rather than inflationary due to QE), flight to safety and anticipation of Fed's policy responses interact to drive funds flowing into different asset classes at different times. Armed with this knowledge, you will be able to respond appropriately to what the market is telling us and stay invested in the right trending assets. Remember, as the markets swing from one extreme to the next, these provide further trading opportunities once you realise their relationships and are ready to position to take advantage of each swing.

While stock picking can help beat market performance, an occasional wrong pick could decimate a portfolio's returns. Company specific risks such as unexpected changes in management, changes in industry regulations, accounting fraud, litigation suits and loss of some big customers could potentially crush stock prices. Hence, for market-timers (swing traders) who are apprehensive of stock picking strategies, they can consider swing trading using sector ETFs. Afterall, a large part of a stock's price movement is tied to the sector movements. Leveraged sector ETFs, while volatile, can be quite safe as sectors don't collapse to zero values like stocks could while giving investors/traders an extra boost to otherwise slower but more stable index movements. There are many choices of sector ETFs to choose from and one should be looking at their liquidity and structures to ensure they are not easily manipulated and their structures are not faulty to what they are intended to measure and capture. ETFs can likewise be used to capture gains from inter-market correlations and movements as institutional funds rotate causing the regular ebb and flow we have seen across different asset classes.

Thanks for visiting. See you in two weeks' time!