What is Intermarket Analysis?
Intermarket analysis is a technique used by traders and investors to identify and analyze relationships between different financial markets. By studying the correlations and divergences between various asset classes, such as stocks, bonds, currencies, and commodities, traders can gain valuable insights into market trends and make more informed trading decisions.
The concept of intermarket analysis was popularized by John J. Murphy, a renowned technical analyst, in his book "Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets." Murphy's work emphasized the importance of understanding the interconnectedness of global financial markets and how events in one market can impact others.
Why is Intermarket Analysis Important?
Intermarket analysis is crucial for several reasons:
- Identifying market trends: By analyzing the relationships between different markets, traders can identify broader economic trends and market sentiment. This information can help them make more accurate predictions about future price movements.
- Risk management: Understanding the correlations between markets can help traders manage risk more effectively. For example, if a trader holds a long position in stocks and identifies a negative correlation with bonds, they may choose to hedge their stock position with a bond investment.
- Diversification: Intermarket analysis can help traders diversify their portfolios by identifying uncorrelated or negatively correlated assets. This can help reduce overall portfolio risk and potentially enhance returns.
- Confirmation of trading signals: By comparing signals from different markets, traders can confirm the strength of a trading signal. For example, if a bullish signal in the stock market is accompanied by a bullish signal in the bond market, it may indicate a stronger likelihood of a positive move in stocks.
Key Intermarket Relationships
Some of the most important intermarket relationships that traders should be aware of include:
Stocks and Bonds
The relationship between stocks and bonds is one of the most widely followed intermarket correlations. In general, stocks and bonds tend to move in opposite directions. When the economy is growing, and investors are optimistic, they tend to favor stocks, which can lead to rising stock prices and falling bond prices (and rising yields). Conversely, during times of economic uncertainty or market turmoil, investors may seek the safety of bonds, leading to falling stock prices and rising bond prices (and falling yields).
Commodities and Currencies
Commodities and currencies also share important relationships. Commodity-linked currencies, such as the Canadian dollar, Australian dollar, and New Zealand dollar, tend to strengthen when commodity prices rise and weaken when commodity prices fall. This is because these countries are major exporters of commodities, and their economic growth is closely tied to commodity prices.
Stocks and Commodities
The relationship between stocks and commodities can vary depending on the specific commodity and the economic environment. In some cases, rising commodity prices can be a positive for stocks, as it may indicate strong economic growth and rising demand. However, if commodity prices rise too quickly, it can lead to inflation concerns and potentially hurt stock prices.
Currencies and Bonds
Currency movements can also impact bond prices and yields. When a country's currency strengthens, foreign investors may be attracted to its bonds, as they can earn higher returns when converted back to their home currency. This increased demand can lead to rising bond prices and falling yields. Conversely, when a currency weakens, investors may sell bonds, leading to falling prices and rising yields.
Practical Examples of Intermarket Analysis
Here are some practical examples of how intermarket analysis can be applied in trading:
Example 1: Stocks and Bonds
Suppose a trader is considering a long position in a stock index, such as the S&P 500. By analyzing the relationship between stocks and bonds, the trader notices that bond prices are falling (and yields are rising), which may indicate that investors are optimistic about the economy and are shifting funds from bonds to stocks. This could be a confirming signal for the trader to enter the long stock position.
Example 2: Commodities and Currencies
A trader is analyzing the Canadian dollar and notices that it has been strengthening recently. Upon further investigation, the trader discovers that oil prices have been rising, which is a positive for the Canadian economy. Given the positive correlation between oil prices and the Canadian dollar, the trader may choose to enter a long position in the currency.
Example 3: Stocks and Commodities
An investor is considering adding a gold mining stock to their portfolio. By studying the relationship between gold prices and the stock, the investor notices that the stock tends to outperform when gold prices are rising. If the investor believes that gold prices are likely to rise based on their analysis of the current economic environment, they may choose to buy the gold mining stock.
Conclusion
Intermarket analysis is a powerful tool for traders and investors seeking to understand the complex relationships between different financial markets. By studying the correlations and divergences between asset classes, traders can gain valuable insights into market trends, manage risk more effectively, and make more informed trading decisions.
To successfully apply intermarket analysis, traders should stay up-to-date on global economic events, monitor key intermarket relationships, and use a combination of technical and fundamental analysis. By incorporating intermarket analysis into their trading strategies, traders can potentially improve their chances of success in the dynamic and ever-changing world of financial markets.