How to use intermarket analysis in your trading
Intermarket analysis is often considered a form of technical analysis that investigates and evaluates the price activity of a variety of assets in relation to each other. Because it also takes into account fundamentals in its analytical process, intermarket analysis can also be classified as a type of fundamental analysis.
How does it work? What are the principles of intermarket analysis? How can you take advantage of it in your trading? Let’s have a look at everything you need to know about intermarket analysis before you integrate this concept into your trading strategy.
What is intermarket analysis?
Intermarket analysis is the process of evaluating an investment by looking at its historical relationships to other (sometimes multiple) related markets in addition to its own individual merit.
The theory assumes that assets like currencies, stocks, bonds, and commodities, among other financial markets, are all connected in some way, and movement in one area often impacts another in a relatively predictable manner.
An investor who has an awareness of intermarket analysis will be looking at certain economic indicators in an attempt to forecast future market activity. The most popular indicators include, but are not limited to, growth rates, inflation, interest rates, and employment figures.
Intermarket analysis and correlation
One simple method of exploiting intermarket analysis is studying the correlation between different asset classes, measuring the strength of the linear relationships between two variables, and computing their association through a correlation coefficient.
A positive correlation in this instance goes as high as 1, representing perfect correlation – which is very rare. A reading of -1 depicts a perfect negative correlation – also rare, with 0 representing no relationship of any shape or form. Usually, a positive correlation means both investments go up or down together, while a negative, or ’inverse’, correlation means one investment goes up and the other goes down.
Investors using these strategies assume that one asset class will move in one direction and the other will eventually follow, or move the opposite way, in a relatively consistent and predictable manner.
The order of leader vs follower can change over time, depending on the macro-economic environment, as well as a variety of other factors. With so many moving parts to track, it takes experience to understand all of these various relationships and their repeated patterns, but being able to understand these relationships may help you make better trading and investment decisions.
What are the most traditional intermarket relationships?
Here are just a few real-world examples of this theory in action:
- As Australia is one of the foremost exporters of gold (5th largest) and other precious metals, investors often think of trading the Australian dollar (AUS) as a proxy for trading gold. When the price of gold increases, so does the Aussie dollar.
- New Zealand’s currency (NZD) is also correlated to the price of gold, as the country is also a large producer of gold and other precious metals. Therefore, the value of the local currency is often positively correlated to the price of metals. Moreover, the economy of New Zealand is strongly linked to Australia’s, which historically has a strong relationship with gold.
- Canada and its major oil exports to the US have a significant effect on the USD/CAD. If American demand for oil increases, then oil prices rise, and the USD/CAD decreases, as the CAD is bought. Conversely, when demand for the US drops, then the price of oil can also fall and negatively impact demand for the CAD, which tends to support the USD/CAD currency pair. The same is true of Canada’s relationship with Japan, as they also have to import a great deal of oil. The CAD/JPY then positively correlates with oil prices.
- Commodities are most commonly priced in US dollars, and as such, any movement of the USD can affect their value. If the USD falls, investors of other currencies can potentially purchase a greater amount of commodities for the same value, which would lead to an increase in demand for commodities, and also an increase in their prices.
- The relationship between the US and Japan is very strong and economically advantageous, as they are highly integrated via trade and are large markets for each other’s various imports and exports. Therefore, Japanese indexes usually follow what happened on Wall Street the day before.
- As Japan is an exporting giant, the country heavily relies on exports, which means that the value of the Japanese Yen (JPY) strongly impacts the level of the country’s exports. A weaker Yen indicates that Japanese products may be sold for less money in other countries, making them more appealing than local competitors. As a result, Japanese exporting firms tend to see their stock value climb as the Yen declines. That’s why a negative correlation exists between the JPY and the main Japanese stock indexes, especially the Nikkei.
Intermarket relationships, inflation and deflation
Two significant factors that affect intermarket analysis overall are inflation and deflation.
The relationships that are most obviously impacted by inflation/deflation include bonds and commodities, stocks and bonds, and commodities and the US dollar.
In an inflationary economic environment the following relationships are generally observed:
- Bonds and Stocks move positively (bonds tend to move first, stocks then follow)
- Bonds and Commodities move inversely
- US Dollar and Commodities move inversely
It’s worth remembering that an inflationary environment doesn’t necessarily mean out-of-control inflation. It can just mean that inflationary forces are stronger than deflationary forces.
Looking for ways to protect your portfolio in times of higher inflation and rising interest rates? Have a look at our dedicated article – How can traders hedge against inflation?
In a deflationary environment the following relationships are observed:
- Bonds and Stocks move inversely
- Bonds and Commodities move inversely
- Stocks and Commodities move positively
- US Dollar and Commodities move inversely
Why is intermarket analysis important for your trading?
The benefit of using intermarket analysis as one part of your investment strategy lies in having a greater insight into what trends will emerge ahead of time and which direction potential investments may be heading, depending on which asset classes they belong to.
Having the ability to do so should contribute to a higher success rate in determining when to exit current positions and enter more promising positions.
Choosing assets that have a relatively low correlation to one another as a result of intermarket analysis is also important for diversity in your portfolio, as you’re able to protect against any one market movement affecting more than one of your investments. Remember that diversification is a key concept in money management.
If you want to learn more about it, read our dedicated article – How to better diversify your portfolio.
It’s important to note that past performance doesn’t necessarily indicate future performance, and intermarket analysis is just one way to approach the markets, but having a basic understanding of how markets move in concert with each other is a great advantage in being able to spot the best trading and investment opportunities.
It could either be over the short-term with derivatives and leveraged products like CFD through scalping or day trading strategies, or through mid to long-term investment plans with more conservative techniques like ’buy and hold’.
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