It seems obvious to state that markets are connected and moves in one market are often related to moves in other markets. But in 1991, this was a new idea. In that year, John Murphy published Intermarket Technical Analysis Trading Strategies for the Global Stock, Bond, Commodity, and Currency Markets to provide the first explanation of the relationships between markets. First, let’s look at Murphy’s ideas and then we can develop trading strategies based on intermarket relationships.
Many traders believe intermarket relationships can define the best time to buy and sell asset classes. For example, 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. As the economy overheats and inflation increases, commodities should be a safe investment.
In his book, Murphy went a step further and identified clear relationships between stocks and bonds, bonds and commodities, and commodities and the dollar. This concept makes sense. If the value of the dollar falls, we would expect to see the price of gold rise, for example, and as gold rises we would expect gold mining stocks to do well. Intermarket relationships grew out of these intuitive ideas.
Murphy also explained that by understanding these relationships, traders can develop insights into what could come next in the markets. He also noted intermarket relationships change over time. In general terms, they are different depending upon whether we are experiencing inflation or deflation.
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Inflation has been the more common economic condition since the Great Depression. Just a few years ago, standard economic theory held that we would almost always enjoy the benefits of inflation. Of course we know that’s not true anymore but let’s look at the expected intermarket relationships during inflationary periods.
Important relationships in this environment include:
- A positive correlation between stocks and bonds with bonds usually leading when trends reverse
- A negative correlation between bonds and commodities
- A negative correlation between the US dollar and commodities
Correlation is the mathematical relationship between two data series. In this case we are using prices as the data series. A positive correlation means the two prices should trend in the same direction. A negative correlation means we would expect the general trends to move in opposite directions. Correlations are based on general trends and not necessarily the day to day moves in price.
A positive correlation between stocks and bonds means when stocks are in an uptrend we expect bonds to be in an uptrend. Remember that bonds rise when interest rates fall. This relationship held through the great bull market that ran from 1982 through 2000. Interest rates on ten-year Treasuries fell from more than 14% to just 6% over that time. As rates fell, bond price rose along with stock prices, exactly as the intermarket relationship forecast.
As bonds rose, commodities fell during that time with gold falling from more than $500 an ounce to about $260 ounce. Corn prices also fell from $3.84 a bushel to about $1.77.
As commodities fell, their negative correlation with the dollar tells us we should expect the dollar to rise. Data for the US dollar trade-weighted index begins in 1985 and the dollar was lower in 2000 than it was when the data series began. This relationship did not hold up as predicted.
The failure of intermarket relationships to hold up over the long run led to a reevaluation of the theory and the new idea that in a deflationary environment some of the relationships will change.
In a deflationary environment, 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
With the revisions to the theory, we may be getting into an exercise in curve-fitting. Under this theory there will be times when stocks and bonds move together and other times when they move in opposite directions. The distinction is supposed to be defined by inflation expectations. In other words, we have times when intermarket relationships work and times when they don’t.
This less precise relationship can be confirmed by measuring the correlations of different price series over different time periods. The chart below shows correlations between the dollar and gold prices, the dollar and oil prices, and oil and gold prices. The relationships vary a great deal over time with correlations moving from positive to negative in an almost random fashion.
Because correlations change over time, intermarket strategies are best used for short-term trading. Correlations of different asset classes should be calculated every few months and portfolios built to benefit from the correlations. For example, adding assets with negative correlations can reduce risk. However, because correlations change the portfolio will need to be reviewed and rebalanced relatively frequently.
In other words, intermarket trading strategies are not really very useful for individual investors. But intermarket investment strategies can be useful in the long run. To implement these strategies, we need to understand what different asset classes represent.
Historically, emerging market stocks have delivered the best returns but carry the greatest risk. Many emerging markets are highly correlated to natural resources because energy and mining sectors may represent a large portion of the market capitalization of these markets. Emerging market exposure can then be viewed as an allocation to natural resources in a portfolio.
High yield bond funds, or junk bonds, often have significant exposure to energy. Investing in junk bonds is therefore an investment in the energy sector rather than the fixed income asset class but the bonds act like stocks sometimes and like fixed income at other times. When stocks are moving up, junk bonds tend to deliver below market returns. When stocks turn down, junk bond default rates tend to rise and these funds deliver worse than average returns. Almost all of the time, junk bond funds are not the best investment possible. But there will be times when the funds do outperform, often delivering better returns than large cap energy stocks in a bull market. Correlation analysis could identify those times.
Gold also outperforms at times even if it underperforms in the long term. Since 1970, gold has delivered an average annual return of about 8% a year. But all of the gains came in the 1970s (when gold first began trading) and since 2002. For more than 20 years, gold delivered negative returns.
Rather than relying on intermarket relationships which sound good, traders should consider developing an asset allocation plan. The plan should reflect your risk tolerance. If you are in your twenties with nearly fifty years to retirement, you could be nearly 100% invested in stocks with an allocation to emerging markets to add exposure to natural resources. If you are concerned that hyperinflation is likely, add a small allocation to gold no matter what your age. If you are nearing retirement, fixed income allocations are prudent. If you plan to retire in less than five years, it could be best to allocate 25% or more of your portfolio to short-term fixed income investments. Even a return of 0% is better than a negative return that could force you to delay retirement.
When it comes to intermarket relationships, it could be best to remember that sometimes they work and sometimes they don’t. Hedge funds and sophisticated individuals comfortable with calculating correlations could benefit from the relationships when they work. Most of us should ignore this idea and stick with what does work, concepts like asset allocation, value and momentum investing that have withstood the test of time.