For those traders who want a clear and brief explanation
of various concepts often touched on in technical analysis and trading,
we offer Traders' Notes.
INTERMARKET ANALYSIS
Intermarket analysis, one of the pillars of technical analysis, is the
comparison of the price action of one market to another. This comparison
can be as simple as placing two different charts side by side. The most
widely endorsed use of intermarket analysis hails from the Dow theory,
whereby the movement of the Dow Jones Industrial Average (DJIA) is compared
with the Dow Jones Transportation Average (DJTA). The theory holds that
if both averages are trending higher, the investor should conclude that
the underlying fundamentals driving the stock market are sound and that
the trend of the market is up. When one of the averages begins to diverge
-- for example, one average trends to higher highs, while the other average
fails to make a higher high -- a warning is signaled (Figure 1) but not
necessarily a reversal, as the markets may get in gear at a later point.
The key is that intermarket analysis can aid the investor in determining
the trend of the market as well as alert the investor to a potential trend
reversal.
FIGURE 1: DJIA VS. DJTA. During July 1998, the DJIA
moved to a new high, while the DJTA failed to confirm. This divergence
forewarned of the downtrend.
Intermarket analysis has many uses. An important intermarket relationship
for stock investors and traders to monitor is the one between interest
rates and the stock market. As a general guideline, a rising rate environment
is negative for stocks; likewise, falling rates are bullish for stocks.
A quick look at Figure 2 shows that our proxy for interest rates is
the Treasury bond futures market. As T-bond prices move inversely to yield,
an uptrend in T-bond prices indicates a falling interest rate. Note that
the T-bond market has been in an uptrend for more than a year (falling
rates), and the stock market has followed suit. T-bonds peaked in October
1998 and have since moved sideways, while the stock market has continued
to rise. At this point, we can conclude that a stable interest rate environment
is still supportive of the stock market.
FIGURE 2: S&P 500 VS. T-BOND FUTURES. The T-bond
market has been in an uptrend for more than a year (falling rates), and
the stock market has followed the same trend.
Another example of intermarket analysis can be seen in how the commodity
market compares with the interest rate market. The guideline here is that
falling commodity prices imply low inflation pressures and therefore are
supportive of T-bond prices (Figure 3). On the other hand, if commodity
prices are rising, then bond investors become concerned about inflation
reducing the spending power of T-bonds, and consequently, T-bond prices
tend to fall.
FIGURE 3: T-BONDS VS. CRB. Falling commodity prices
are a sign of low inflationary pressure and can lead to a bond market rally.
Another feature of intermarket analysis is deciding which group of stocks
to trade or invest in. Figure 4 compares NASDAQ to the Standard & Poor's
500. You can see that during December 1998, the S&P 500 consolidated,
tracing out a slight downward pattern, while NASDAQ continued to make higher
highs and higher lows. This example of superior relative strength indicated
that between the two, the better place to invest was in NASDAQ stocks.
FIGURE 4: NASDAQ COMPOSITE VS. S&P 500. During December
1998, the S&P 500 consolidated, tracing out a slight downward pattern
while NASDAQ continued to make higher highs and higher lows. The superior
relative strength was a good sign for NASDAQ.
Figure 5 is an example of group analysis. Here, looking at how various
sectors are performing relative to each other is an additional tool available
to the investor. The two indices are the Morgan Stanley Cyclical Index
and the S&P 500 Retail Index.
FIGURE 5: MORGAN STANLEY CYCLICAL INDEX VS. S&P 500
RETAIL INDEX. The stocks in the retail index were a better opportunity
compared with the stocks that make up the cyclical index.
The two weekly charts tell an interesting story. The cyclical index peaked
in July 1998 and has not made a new high in 1999, while the retail index
has. This indicates that the stocks in the retail index are the better
opportunity compared with the stocks that make up the cyclical index.
Another comparison is the gold/silver stock index (XAU) compared with
the price of gold (Figure 6). Note how the gold market, after a rally in
the fourth quarter, traded with a series of lower highs and lows, and the
XAU has followed the same course. The gold market and the XAU continue
to confirm the relative weakness of this stock group compared with the
stock market.
FIGURE 6: XAU VS. GOLD FUTURES. After a rally in the
fourth quarter, the gold market traded with a series of lower highs and
lows. The XAU followed the same course. The gold market and the XAU continued
to confirm the relative weakness of this stock group compared with the
stock market.
Many market analysts have written about intermarket analysis; two of the
best-known are Martin Pring and John Murphy, with the latter covering the
topic with his popular Intermarket Technical Analysis. As they note,
intermarket analysis is a powerful technique for traders and investors.
The relationships described here are not static. Therefore, developing
a working knowledge based on a historical review of these relationships
is time well-spent.
FURTHER READING
Forest, Richard [1992].
"Intermarket Analysis And The Deutschemark," Technical Analysis
of STOCKS & COMMODITIES,
Volume 10: February.
Hartle, Thom [1991].
"John J. Murphy, Intermarket Analyst," interview, Technical Analysis
of STOCKS & COMMODITIES,
Volume 9: June.
Murphy, John J. [1991].
Intermarket Technical Analysis: Trading Strategies For The Global
Stock, Bond, Commodity, And Currency Markets, John Wiley & Sons.
_____ [1992]. "The Link Between Bonds And Commodities," Technical
Analysis of STOCKS & COMMODITIES,
Volume 10: May.
_____ [1992]. "The CRB Index/Bond Ratio," Technical Analysis of STOCKS
&
COMMODITIES, Volume 10: July.
_____ [1992]. "Interest Rates And The US Dollar," Technical Analysis
of STOCKS & COMMODITIES,
Volume 10: October.
Pring, Martin J. [1992].
The All-Season Investor, John Wiley & Sons.
Originally published in the March 1999 issue of
Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 1999, Technical Analysis,Inc.
