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Inter-Market Analysis: The Must-Know Primer & Review

|Includes: SPDR S&P 500 Trust ETF (SPY)

Part 1A of a series on the basics of inter-market analysis: a short primer on what it is, why it works and how to profit from it

The big market movers of the past year, a variety of sources and markets have come from a variety of sources, places and markets, but they've affected almost all markets everywhere. As we begin reflecting on the outlook for the fourth quarter, it's worth reviewing the key elements of inter-market analysis and how to profit from them.

This is the first of a series of articles on the basics of inter-market analysis; what it is, and how to use it to improve your performance in your primary market of interest, be it stocks, forex commodities, etc.

Summary: What It Is, Why You Need It

As the term suggests, inter-market analysis is all about studying how different markets are behaving, with any of a number of goals, including:

· Getting a better overall big picture of market sentiment

· Spotting potential arbitrage opportunities

· Seeking advance trend change signals or confirmation of existing trends in another market, as some markets tend to lead others

In essence, inter-market analysis is all about:

· Knowing how and when different assets, asset classes, and markets correlate to the ones in which you trade. Do they tend to move in the same direction (positive correlation) or the opposite direction (negative correlation)? Do they tend to be leading, lagging, or coincident indicators for your market? Once we know if and how and when two separate markets correlate, we can use price movements in one market to help predict movements in our primary market of interest. These relationships can change in the short or long term.

· Watching for normal correlations or divergences from those correlations:

· Normal Correlations: When different markets are moving in the same or opposite direction as they normally do, you can use movements in one market to confirm or even predict movements in another.

· Divergences From Normal Correlations: However when markets that normally trend in the same direction start to diverge, those trend divergences are often leading or coincident indicators of changing market conditions. Over time you'll see how some markets tend to react before others, and so provide advanced notice of changes from which you can profit.

Now let's look at why and how it all works, and how it can help you.

Why Inter-market Analysis Works

Inter-market analysis works because the movements of most globally traded asset markets are indirectly or directly related.

Indirectly: Most markets are indirectly related because they are influenced by the same set of underlying market driving events or trends. Seemingly unrelated global markets are in fact profoundly influenced by many of the same factors, albeit in different ways. In other words a given news item or economic trend can cause certain assets called risk assets (and their markets) to trend higher, and others, called safety or safe haven assets, to trend lower, or vice versa. More on that below in our explanation of risk and safety assets.

Directly: Some markets directly influence other markets. For example a sudden rise in the price of oil or credit (aka interest rates) is an added expense for business and thus hurts stocks and other assets that rise with optimism and fall with pessimism (aka risk assets). Changes in credit markets that affect the cost or availability of credit directly affect most major asset markets, as we've seen from Subprime Lending Crisis, the resulting Great Financial Crisis, the resulting European Debt and Banking Crisis, and the from the resulting attempts to deal with them such as the Fed's QE program and its attempts to curtail or taper it.

Both Directly And Indirectly: Some inter-market relationships are driven by a combination of both indirect and direct links to each other.

Virtually all kinds of assets can be classified as risk or safety (aka: safe haven) assets. Here are somewhat simplified but useful working definitions.

Markets' Indirect Connections

Most markets are heavily influenced by the same big macro-market movers, economic or political events or trends that shape the global economy.

However they don't respond in the same way.

Any experienced market observer knows that a given event or economic trend generally sends some assets higher and others lower, depending greatly on whether they're risk or safety (aka safe haven) assets.

Understanding Risk vs. Safe Haven Assets

If you're not thoroughly familiar with this topic do not move on until the below is clear. It is critical to understanding how to do your own inter-market analysis and will save you a lot of time and money.

· Risk Assets: By definition these rise in times of optimism because they are believed to provide better returns when economies are expanding. For example:

· The classic risk assets include stocks, especially cyclical sector stocks that appreciate the most in times of prosperity when consumers want to spend. Construction, discretionary consumer goods, and travel sectors are classic examples of these. So are industrial commodities like oil, copper or iron that are in higher demand in times of expansion. As we discuss in depth here, in most time frames, most major global stock indexes like the S&P 500, FTSE 100, DAX, CAC, and Nikkei trend in a similar manner.

· Higher yielding currencies tend to rise in times of expansion relative to currencies from nations with lower benchmark interest rates due to demand from carry trade, a more technical forex topic.

See here for details on that, and on risk vs. safety currencies in general, for a deeper understanding of these and how to use forex trends to improve your performance as a trader or even an income investor.

· Safe Haven Assets: rise in times of pessimism because it's believed they'll depreciate less or even appreciate in value. For example:

· The classic safety assets include bonds with the highest credit rating

· Low yielding currencies that tend to be bought as carry traders close out their carry trades in times of fear and seek shelter in these currencies.

NB: THESE LABELS HAVE NOTHING TO DO WITH SAFETY OF AN ASSET AS A STORE OF VALUE. Rather these refer solely to how an asset or asset class typically behaves in response to market optimism or pessimism. For example:

o Sovereign bonds with top credit ratings have historically been considered the classic safe-haven asset because they generally (at least pre-taper era) move in the opposite direction as stocks and other risk assets. Indeed, risk of loss of principal with bonds is generally lower than with stocks, as long you hold them until they mature. However if interest rates are expected to enter a long term uptrend, bonds would be likely to see a long term drop in price. Bond investor would then need to choose between selling them at a loss, and holding them until maturity for years while missing the chance for higher income for the same level of risk.

o Similarly the US dollar has for years been ranked among the leading safe haven currencies, even though it's been in a decade long decline against most other major currencies. See here for a full discussion of how the USD has fared over the course of decades against many 'risk' assets.

What Determines The Strength Of These Indirect Correlations?

The strength of these positive or negative correlations depends on sensitivity to risk appetite (greed) or risk aversion (fear). In other words:

· Some risk assets will rise more on good news than other risk assets, and fall harder on bad news.

· Some safe haven assets will fall harder on good news than others, and rise higher on bad news.

For example:

· The largest global stock indexes tend to have very high positive correlations to each other because they're all risk assets. In other words, they tend to move in the same direction, not necessarily on a daily basis, but usually over a given number of days (barring any extremely good or bad country or region-specific developments). That's because the same news or longer term economic developments affect all of them more than local developments in their own native economies. This is especially true for smaller and more export-oriented economies that are highly dependent on specific large trading partners.

· Bond markets tend to move in the opposite direction of stocks because bonds are safety assets

· Certain currencies tend to trend with risk assets and are called risk currencies. Others trend with safe haven assets and are called safety currencies. Here's a how they rank as risk or safe haven currencies.

Source: The Sensible Guide To Forex: Safer, Smarter Ways to Survive and Prosper from the Start, Cliff Wachtel, John Wiley & Sons, 2012

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· For example, Japanese Yen (JPY) and Australian Dollar AUD) in recent years have tended to have very negative correlations to each other. That's because the JPY is a strong safe haven currency (note how it's all the way on the right). That is, it tends to fall hard in times of optimism and rise strongly when markets are fearful. The AUD is the top ranking risk currency, and thus behaves in the opposite manner, rising on good news and falling on bad news. Thus the two tend to move in opposite directions when there is a clear bias to risk or safety. The same could be said when comparing other currencies that are on opposite ends of the currency risk spectrum.

For the full story on currency rankings, their basis, and how they can change, see here.

Other Market Drivers Can Override Risk Appetite

Note that the above relationships are often obscured or overridden by other market forces, especially on daily or shorter term time frames. For example, it's common to see risk assets rising as a group yet see one particular risk asset falling due to some long or short term phenomenon that mostly affects just this asset. For example, if global stock indexes and other risk assets are rallying, one would expect the AUD to be soaring in tandem. However if there's bad news for the Australian economy, the AUD could easily be lower

Direct Inter-Market Relationships

Some markets have a clear direct influence on others. For example as noted above:

Oil And Stock Indexes: Although crude oil is a risk asset that usually tracks or follows stock indexes, if oil prices suddenly spike (typically from supply concerns due to Mideast tensions) they can send most risk assets lower because demand for oil is inelastic in the short term and cuts earnings and growth.

Credit Markets And Currencies: As we discuss in some detail here, one of the most influential drivers of a given currency's price and trend is:

· Its central bank's benchmark rate and related bond rates, relative to those the other major currencies. The higher its benchmark interbank and bond rates, the stronger the currency's uptrend versus those currencies.

· Similarly, any data that changes expectations about the direction, timing, or size of increases of decreases in these benchmark and related bond rates.

Some Asset Markets Have Direct And Indirect Relationships

In addition to being influenced by the same global market moving events or economic trends, some asset classes act directly on others.

· EUR and USD: These two currencies move have a strong negative correlation powered by both indirect and direct factors:

· Indirect: Out of 8 major currencies the EUR has the fourth highest benchmark interest rates, a fragile EU economy desperate for any good news makes the EUR a clear risk currency that moves up with optimism.

· Direct: These are by far the two most widely traded currencies, so when markets are buying one, they tend to be funding those purchases via sales of the other. Thus they tend to move like two children on a seesaw, one up, one down.

See here for more on how the major currencies rank and why.

These Relationships Can Change In Both Short And Long Term

For example:

Oil and stocks: as noted above, oil normally follows stocks, a temporary sudden spike in oil prices due to supply fears (typically due to Mideast turmoil) means rising oil prices pushing stocks lower. In other words, oil changes from being a risk asset that follows stock indexes into a safe haven asset that drives stock indexes in the OPPOSITE direction, with oil prices rising on oil supply fears and stocks falling.

The USD and stocks: The USD has usually been a safe haven asset in recent years, while stocks or stock indexes are risk assets, and so they've tended to move in opposite directions. However as we discuss here, like any currency, the USD is strongly influenced by expectations about the future direction of benchmark USD bank and bond rates. The Fed has said it will not raise rates until there are certain improvements in US economic data. Thus when markets see that data improving, or expect it to improve, not only do stocks rise as they normally do with good data, so does the USD. That rise in the USD isn't because the USD has become a risk asset, but rather because that same data or news is improving expectations for the pace and size of interest rate increases.

Ok, So How Do I Use Actually Use Inter-Market Analysis?

Note that this is just an introductory article to a huge topic that can fill volumes, and that specifics vary depending on your specific market of interest. That said, here are some generally applicable guidelines.

Understand what really drives your asset of interest/Know your market movers: It isn't enough to just know if it's a risk or safety asset. For example as noted above, the USD may generally behave as a safety asset, but more fundamentally it moves with US interest rates and expectations about their future direction. Indeed, as we discuss here, interest rates and expectations about them are prime determinants of whether a given currency is a risk or safe haven asset.

Find good barometers of those factors that move your market: For example:

· For monitoring risk sentiment, a major stock index like the S&P 500 tends to be as good an overall risk appetite barometer as any. It's got the largest stock index by market capitalization, and thus by nature shows how a wide range of sectors and regions are feeling. If you trade during hours when US markets are closed, use one of the largest indexes that are open during the session you trade, be it Asia or Europe. See here for more on how and why forex traders need to monitor stock indexes. However as we discuss here, your choice of stock index will vary depending on your estimated holding period, time frame, and depending on those, the hours during which you trade.

· Income investors need to pay extra attention to interest rate trends for the currency in which their investments are denominated, because both bonds and dividend stocks are highly interest rate sensitive.

· Commodity prices are more influenced by specific supply and demand considerations. Indeed unlike stocks and currencies, commodities tend to behave like risk assets only to the extent that risk appetite or optimism influences supply. Thus commodities for which demand varies most with economic conditions (like copper or iron) tend to be more sensitive to changes in risk sentiment.

Want To Know More?

Inter-market analysis is a huge topic, so this series is just to provide an overview so that you're better able to pursue more in-depth study on your own. See the next two parts of this series:

What Everyone Must Know About Currencies: Profiting From Risk Rankings

Stock Indexes And The One Chart All Must Watch

For more in-depth coverage of this topic, and all topics covered in this series on inter-market analysis, see The Sensible Guide To Forex: Safer, Smarter Ways to Survive and Prosper from the Start (Wiley 2012).

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DISCLOSURE/DISCLAIMER: The above is for informational purposes only and not intended to be specific trading advice. In other words if somehow you lose money based on the above I take no moral or legal responsibility for it. Deal with it.