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Inter-Market Relationships Analysis

There are three major schools of thought concerning the capital markets; well, four if one considers the plaintive bleating of the conspiracy theorists. The economists and fundamental analysts can generally be lumped together, as they believe that the future is a general extension of the past, and as such, are prone to believe that a trend, once established, will simply continue. The technical analysts, on the other hand, look at a dizzying array of indicators to measure trend strength, money flow, and periods of excess. While nice in concept, the tools and methods often lead to contradictory conclusions, especially at the onset of a powerful trend. After many years of frustration, it simply appeared that there had to be a better, and hopefully, easier way. From this came our work in the area of inter-market relationships analysis.

What is intermarket analysis? In a sense, it starts with the basic belief that as money flows from one area to another, it does so based on the rational decisions of the entire market place. Long before the economists realize that a fundamental sea change has taken place and have begun to revise their estimates, the forces of supply and demand have painted a picture of what the future will likely hold. Beyond that, we all have to realize that the markets do not operate in a vacuum- that there is both a cause and effect to the movement of liquidity from one area to another.

Consider that, say, on a simplistic basis the price of oil can have an impact on the price of corn. If energy prices were to rise, pushing inflationary expectations and interest rates higher, it could lead to an economic slowdown in those Asian countries that are net importers of oil. A drop in the demand for pork could result, leading to a contraction in this one market and an inevitable decline in demand for feed.

What I do is try and show, through the use of charts, what the relationships are and how the leads and lags between markets work. I not only want to understand the trend itself, but also the fundamental forces that created it. To trade effectively, one must have conviction. To win big, one must understand when to buy the dips, use leverage, and act boldly while others are getting flushed out by the periodic corrections. Beyond that, if one understands the forces that are perpetuating a move in a market, it becomes much easier to look for major changes in direction.

In a sense, then, I have found that the most accurate economist is the market itself. It is far easier to forecast economic activity from the behavior of capital market prices than it is to forecast the capital markets from an economic thesis. It is specious to suggest, for instance, that Japan will recover from its deflationary environment if longer-term, and therefore market determined, interest rates fail to rise. It is foolhardy to predict an imminent economic collapse when stock market prices are making new highs. It is illogical to hang on to a belief that the global economic system is weakening if ocean shipping rates are climbing.

The final challenge, however, in intermarket work, comes from interpretation. In early 1999 we showed that the equity values of the oil producing companies had diverged to unsustainable levels from the price of crude oil itself. It became apparent that one side or the other had to give. By late in the year the entire divergence had been wiped out- not by a collapse in this sector, but by a near tripling in the price of crude oil. As we move deeper in the year 2000, we can see a host of divergences that still need to be closed. The value of the U.S. equity market in terms of the yen suggests that, in spite of our near-term negative view on the yen, this currency is still substantially undervalued; either that, or equity valuations in general must decline.

The same is true for gold, which not only moves in relation to oil and bond prices, but also within the entire commodity complex. I can look at the valuations of the gold-mining producers and suggest that that there is a complete absence of speculation in this area and that current depressed levels are indicative of a major bottom.

In summary, we pursue the analysis of the markets through the relationships and movements of the markets themselves because they represent the sum total of the economic decisions of most, if not all, of the world. Rather than rely on the opinions of one person, no matter how accurate he or she may have been in the past, I have found a greater authority. There appears to be no end to the conclusions that can be drawn if a little understanding, imagination, and pure common sense is applied. Major changes in commodity prices affect the bond markets of different countries in different ways, depending upon their economic structure. The fate of copper tends to lead demand for semiconductors, while bond prices move inversely to the energy complex, while leading major directional changes in commodity prices. While central bankers use the financial system as a conduit to transmit small changes in the availability of bank reserves into the end product of final demand for housing and automobiles, they acknowledge that the process works with a significant lag. What is it? How long does it take? What sectors are affected first? When opportunities dry up in one sector, where does money head to take advantage of the next cycle? That, in a nutshell, is what inter-market analysis can tell you if you learn what to look for. Which makes it a grand endeavor and a continuing challenge, but always worth the effort.

 

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