Traders are always looking for an edge. By an edge, we mean some bit of information that helps them make money. Smart traders understand their edge will most likely be found in information that other traders aren’t looking at.
The reason for this is found in the old saying that “to know what everyone knows is to know nothing.” This old saying drives a lot of trading decisions.
Take, for example, a moving average crossover. There was a time when this strategy worked well. The idea is to buy when prices close above a moving average and sell when the close is below the moving average. But, the success of the strategy led other traders to adopt the approach.
As more traders followed the strategy, some began searching for an edge. They might shorten the length of the moving average trying to generate signals earlier. Or, they might change the type of the moving average used or add percentage bands to generate quicker signals.
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It becomes a form of an arms race with each trader trying to beat the other, and in the end the most well known indicators tend to lose their effectiveness.
A Less Studied Approach to Markets
Technical analyst John Murphy spent many years working in the markets and noticed that some markets tend to be related to other markets. He published Intermarket Technical Analysis Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets in 1991 to explain his observations.
Murphy noticed that as the economy dips into recession, buying bonds should be a winning strategy because the Federal Reserve should cut interest rates and cause bonds to rise. As the recession ends, stocks should be the place to invest to benefit from earnings growth.
Others had noticed this idea before, but he took it to the next level. He noticed that some markets tended to turn ahead of others. He found that by recognizing which market was leading, he could develop a trading strategy.
The strategy depended upon the economic backdrop. He found inflation was the critical factor to understand. When inflation is low, he found that we should expect:
- A negative correlation between bonds and stocks
- A negative correlation between commodities and bonds
- A positive correlation between stocks and commodities
- A negative correlation between the US Dollar and commodities
Murphy’s approach tells us that if bonds are falling and interest rates are rising, we should expect higher stock prices unless inflation accelerates. Traders adopting this approach will need to keep an eye on inflation.
The Next Level of Research
Economists working the CME have expanded on Murphy’s work and dug deep to spot additional relationships between markets. One of their finds is that soybean oil prices often lead the movement in crude oil prices.
In a recent paper, they noted, “Soybean oil prices peaked on November 9, 2017, at 35.38 U.S. cents per pound and began a 10% sell off that started two and a half months before the recent peak in crude oil prices (Figure 1). This is the eleventh such episode of soybean oil prices leading crude oil prices since 2005.”
Why does this work? Well, the researchers don’t know.
“We remain unsure of the exact reason why soybean oil and other vegetable oils prices tend to lead crude oil prices, but we suspect that it results from two factors:
1) the existence of biofuel mandates in over 60 countries around the world (including the U.S. nations in the E.U., Brazil and China), and
2) the modest size of the veg oil market in comparison to the vastness of the crude oil market.
The latter is roughly 20x larger and via the biofuel mandates small fluctuations in crude oil supply and demand conditions can have an outsized impact on vegetable oil prices – impacts that may be moving vegetable oil prices in advance of crude oil prices on many occasions.”
This theory does make sense because biofuel mandates divert soybeans to the energy markets. Since a large amount of crop production is now converted to fuel, it makes sense that a relationship exists between the two markets.
What Lies Ahead?
This observation about oil and soybeans can now be combined with Murphy’s work.
- A positive correlation between stocks and commodities. This implies we should expect stocks to move higher when the oils mount a rally.
- A negative correlation between bonds and stocks. This implies we should expect higher bond prices and lower interest rates if stocks decline or lower bond prices and higher rates if stocks rally.
This is certainly a novel approach to the stock market but one that is worth considering. Many analysts are bullish on the stock market and one market they not be watching is the oil market. That market could be turning higher.
Although a bottom is not obvious in the chart, soybean oil does show a similar pattern.
The higher low seen in early March could indicate the extended decline in soybean oil prices is near. That, according to the CME research, should mark the turning point in oil and in the stock market according to Murphy’s work.
This analysis may not be something all investors will find worth considering. Many prefer to stick to fundamentals or traditional technical tools. But, intermarket relationships have been a tool investment professionals have followed for almost thirty years and many have found success with the technique, especially at market turning points.
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