The basic assumption of Intermarket analysis is that all markets are related and what happens in one market is very likely to have an effect on another market. At a macroeconomic level, the four interrelated markets are the Bond, Stock, Commodity and Currency markets, although in our models we do not take into account the currency markets as this market is not part of our investment strategy. Our Intermarket analysis is the analysis of more than one related asset class or financial market on a macroeconomic and microeconomic level. Our analysis looks at several strongly correlated markets or asset classes such as bonds, stocks and commodities with an in-depth analysis in equity sectors and industries.
To clarify the interaction of the Bond, Stock and Commodity markets within our Intermarket model we can use figure 5.1.
Figure 5.1: The Intermarket Model
As explained in the Business Cycle section, the beginning of a new cycle starts from the end of its recession point and here below we describe what we expect from Bonds, Stocks and Commodity prices during the development of the Business Cycle.
During a recession when business activity contracts, the economy faces a smaller demand for credit and diminishing demand for Commodities. Less inflationary pressure favours a Discount Rate cut by the Monetary Authorities and the Bond market turns up after bottoming. The Stock market and Commodity market are still in a down trend.
When the recession reaches its lowest level, the Stock market starts to discount the recovery in business activity, and it turns up while increasing Bond prices favour the next recovery (Bonds up, interest rate down). The Commodity market is still in down trend and this favours the bull market in Bonds and Stocks.
An early expansion takes place in the Business Cycle and Commodity prices turn up as their demand is increasing. The economy is now in an expansion, players in the economy demand more and more credit as their business is developing and the cost of money is still cheap. Now Bonds, Stocks and Commodities are trending up.
In the next phase, the economy becomes stronger and stronger. While the Stock market still remains a bull market Bonds turn down due to the demand for credit and inflationary pressures caused by soaring commodity prices.
The economy approaches its maximum activity. The growth of interest rates hurts the expansion of the economy and companies’ earnings. The Stock market discounts the next contraction in the economy, and turns down as Bonds did previously.
The last stage of the cycle sees a contraction in the economy. Demand for commodities slows due to the contraction in the Business Cycle; Interest rates are still rising and the Stock market discounts further contraction in the economy.
We have described above how hypothetically the financial markets and Business Cycle are linked to each other and what has been discussed above is a theoretical approach, quite logical but still theoretical.
The concept of the six stages was introduce by Martin J. Pring [1] in 1990s who, in order to set the stages of the Business Cycle, takes into account macroeconomic indicators. However, in our Intermarket model we take into account only market prices. Actually, all the required information comes from bond, stock and commodity market prices.
[1] In summer 2005 we developed most of the sector investing analysis published in Martin J. Pring’s book “The Investor’s Guide to Active Asset Allocation: Using Technical Analysis and ETFs to Trade the Markets”, McGraw-Hill 2006.