What is Intermarket Analysis?
Intermarket analysis involves the analysis of more than one related class of assets such as stocks, bonds, commodities, and currencies to determine the strength or weakness of the asset class being considered. The concept was first introduced by John Murphy, a financial market analyst, in his book, “Trading with Intermarket Analysis.”
According to Murphy, traders can use the relationships between the different classes of assets to identify the stage of the investing cycle and distinguish between the best-performing and worst-performing asset classes.
Breaking Down Intermarket Analysis
Intermarket analysis moves away from simply looking at asset classes or financial markets on an individual basis to looking at other assets or markets that are strongly collated, or that show a strong relationship to the asset being analyzed.
For example, when analyzing the US stock market, an investor can look at related markets or asset classes such as the US currency, commodity prices, and the bond market. The prices of commodities prices have a direct effect on the US stock market, and their relationship can be used to get a general sense of the future direction of the stock market.
Intermarket Analysis Correlation
Analyzing the intermarket relationships between two or more variables is usually possible with available data, chart comparisons, or a spreadsheet. Most investors/traders use correlations to analyze the intermarket relationship between one variable and a second variable in a different data set. The degree of correlation between the variables indicates how related or unrelated two variables are to each other.
1. Positive correlation
A correlation study of two variables can either yield a positive or negative correlation. A positive correlation shows that there is a perfect correlation between the two variables or data sets, and it can go as high as +1.0.
A sustained positive correlation of +1.0 is usually rare, but any reading of +0.7 to +1.0 that lasts for a long period of time would indicate that the two variables are statistically significant to each other, and they move in the same direction.
2. Negative/Inverse correlation
On the other hand, a negative correlation, also known as inverse correlation, shows that there is a negative relationship between two variables, and its value can go as low as -1.0. A sustained negative correlation of -0.7 to -1.0 would indicate that the two variables being compared are statistically significant, and they move in the opposite direction.
When the relationship is close to the zero point, it indicates that the relationship between the two variables is weak. If the relationship moves from positive to negative (and vice-versa), it shows that the relationship between the two variables is unstable, and cannot be relied upon to provide trading direction.
Inflationary and Deflationary Relationships
Two of the main factors influencing inter-market relationships are inflationary and deflationary forces. The most clearly defined intermarket relationships that are affected by inflation and deflation include bonds and commodities, stocks and bonds, as well as commodities and the US dollar.
1. Inflationary relationships
During inflation, the economy is deemed to be in an inflationary environment. In such an environment, there is a positive correlation between stocks and bonds; it means that when one asset rises, the other asset follows suit. Typically, bonds change direction before the stocks, so a reversal in the direction of the bond prices may indicate that stocks will follow the same direction.
Further, during inflation, there will be an inverse relationship between the US dollar and commodities, and between bonds and commodities. It means that when one asset class rises, the other asset will move in the opposite direction.
2. Deflationary relationships
In a deflationary environment, the intermarket relationships between various asset classes are similar except for one set of asset classes. The first outcome is an inverse relationship between stocks and bonds; it also means that there is a positive correlation between stocks and interest rates.
Also, there is an inverse relationship between the US dollar and commodities, as well as between bonds and commodities, as was the case with an inflationary environment. The only positive correlation in a deflationary environment is between stocks and commodities.
Importance of Intermarket Analysis
Intermarket analysis provides an insight into the future direction of the markets. Determining the correlation between various kinds of asset classes can provide important confirmations into the probable direction of the asset being considered. For example, certain stocks can provide insights into when the trend is starting, and it can diffuse the problems of entering specific trades or markets too early or exiting the market too late.
However, no method of analysis is designed to be used as the only method of analyzing assets, but they should be used alongside other effective techniques. When intermarket analysis is used solely, it can be rendered ineffective by certain events that affect the relationship between various classes of assets.
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