Intermarket Analysis

Last Updated :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

Table Of Contents

What Is Intermarket Analysis?

Intermarket analysis is a form of technical analysis that examines diverse financial markets by discerning the relationships between various asset classes. It enables investors to establish how the performance of one market can impact another and to what extent. Based on this information, they can make trading decisions.

In intermarket analysis, investors consider multiple assets such as stocks, bonds, commodities, and currencies to receive a complete picture. The intermarket correlation can range anywhere from -1 to +1. -1 signals a strong negative correlation, +1 indicates a strong positive correlation, and 0 shows no identifiable correlation.

What Is Intermarket Analysis?

Intermarket analysis is a research technique experienced investors and investment services companies adopt to understand the market relationship through the correlation between markets.
This technique assumes that the performance of one market can affect another on a scale from -1 to +1.
When the degree and direction of correlation are understood, traders can use the relationship to make investment decisions, such as when to enter or exit a market.
Financial analyst John Murphy popularized the idea in his 2004 book - Intermarket Analysis: Profiting from Global Market Relationships.

Intermarket Analysis Explained

Intermarket analysis, introduced by American financial analyst John Murphy, delves into the connection between various markets through the correlation of specific securities. John Murphy Intermarket analysis approach assesses how one market's conditions can affect another, focusing on stocks, bonds, commodities, and currencies.

For instance, the 2008 financial crisis that began in the United States affected countries worldwide. In the United Kingdom, it caused a recession. In India, it led to decreased investor confidence and reduced gross domestic product (GDP). Forex intermarket analysis became prominent for investors trading in currencies and commodities.

Another such example is the negative correlation between gold and USD. When the price of gold increases, USD decreases and vice versa. This is because investors would rather invest in gold than the USD when the market declines.

That said, it is essential to move on to the technical side of the concept. Different assets are analyzed, and a correlation is established. Let us understand the positive and negative correlation with some examples.

1. Positive correlation

This signifies a direct link between markets or asset classes. Events in one market influence another. For instance, consider bond yields and currency values. High bond yields attract investments, bolstering a country's currency.

Correlation Range for Positive Correlation:

Perfectly positive correlation: +1
Sufficient positive correlation: +0.7 to +1
Positive correlation: 0 to +0.7

2. Negative correlation

Here, an inverse connection exists between markets and assets. When one market falters, the other thrives, and vice versa. A prime example is the relationship between gold and the USD.

Correlation Range for Negative Correlation:

Negative correlation: 0 to -0.7
Sufficient negative correlation: -0.7 to -1
Perfectly negative correlation: -1

While achieving a perfect correlation is uncommon, anything exceeding 70% suffices to identify a meaningful relationship. Conversely, a correlation of zero signifies an absence of a discernible link between the two markets.

Examples

Consider the following examples to understand the concept.

Example #1

Let us consider an example of a forex intermarket analysis. Suppose Jason wanted to invest in USD. However, his fund manager advised against it, as the price of gold was increasing. Therefore, Jason chose to invest in EUR, which had an almost-perfect negative correlation with USD and was not as expensive as gold as of then.

Example #2

Imagine a scenario where geopolitical tensions are rising, leading to uncertainty in global markets. In this situation, an intermarket analyst observes the following relationships:

Gold and currency pairs: As geopolitical tensions escalate, investors flock to gold, a traditional safe-haven asset. This surge in demand causes the price of gold to rise. Simultaneously, currencies like the Swiss Franc (CHF) and Japanese Yen (JPY) strengthen as investors seek refuge in these currencies. It establishes a negative correlation between the USD/CHF and USD/JPY currency pairs, both of which decline.
Oil and stock markets: Geopolitical tensions can disrupt the global oil supply, leading to a spike in oil prices. This increase negatively impacts stock markets worldwide. As oil prices rise, major stock indices like the S&P 500 experience declines, reinforcing the negative correlation between oil prices and stock market performance.
US Treasuries and emerging market currencies: During periods of geopolitical uncertainty, investors often seek safety in US Treasury bonds. This increased demand causes US bond prices to rise. Consequently, the US dollar (USD) strengthens against emerging market currencies like the Turkish Lira (TRY). It establishes a positive correlation between US bond prices and the USD/TRY currency pair, with the USD gaining strength.

By recognizing these intermarket relationships, investors can make more informed decisions.

Importance

Trading with intermarket analysis is complicated. Firstly, identifying a direct or inverse relationship is more accessible, but determining the intensity of impact is extremely difficult. However, once that is done, the investor can use that information to get a clear picture of when to enter or exit a market.

It also helps traders identify new trends and, especially, reversals. One example of this is the stock-bond correlation. Stocks and bonds have a positive correlation. However, bonds change direction faster. Therefore, if bonds signal a reversal, stocks can also anticipate a reversal.

Extreme market situations, such as the 2008 financial crisis and the COVID-19 pandemic, had pushed global economies down. Traders searched for resilient and stable markets and assets. Identifying intermarket relationships early on facilitates investors to reduce losses or at least break even.

Nevertheless, investors should only partially rely on this technique. It is only an accessory that will provide better results when used with other fundamental and technical analysis methods.

Cheat Sheet

An intermarket analysis cheat sheet specifies the relationships between prominent currencies, commodities, and asset classes whose relationship has been pre-determined and established.

Market/ Asset #1	Market/ Asset #2	Reason
Gold increases	USD declines	Due to gold’s higher intrinsic value, traders pull out of USD and invest in gold during economic decline.
Gold goes up	AUD/ USD goes up	Australia is the third largest producer of gold. The value of AUD with respect to USD will go up.
Gold goes up	NZD/ USD goes up	New Zealand is a large producer of gold. The value of NZD with respect to USD will go up.
Gold rises	USD/ CHF falls	25% of Switzerland’s reserves are backed by gold. Swiss Franc increases, leading to a decrease in the pair.
Gold increases	USD/ CAD decreases	Canada is the 5^th largest producer of gold. When CAD increases, the pair decreases.
Oil climbs	USD/ CAD drops	Canada is a leading producer of oil. When CAD increases, the pair decreases.
Gold rises	EUR/ USD rises	Gold and Euro are considered anti-dollars. An increase in these will push the USD down.
Bond yields up	Local currency up	High bond yields make the market attractive, pushing up the currency.
DJIA plummets	Nikkei plummets	US and Japanese markets are positively correlated.
Nikkei plunges	USD/ JPY plunges	JPY is sought during economic distress.

While these relationships are commonly observed, it is essential to remember that a wide range of factors influences financial markets, and correlations can change over time.

Frequently Asked Questions (FAQs)

1. When does intermarket analysis break down?

Some asset classes show a constant correlation in such a way that it is assumed to be their natural relationship. However, due to some unprecedented situation, this natural relationship is broken. For instance, stocks and bonds are positively correlated. But if investors pull out of stocks and trade bonds due to an extreme economic situation, it is a breakdown.

2. Can Intermarket analysis be used for long-term investing as well as short-term trading?

Yes. As with most technical analysis approaches, trading with intermarket analysis is possible and helpful in the long and short term. However, traders should invest much time in identifying the correlation between markets and assets. Stock markets are unpredictable even if they stick to pre-established relations such as stock-bond, gold-USD, etc. Thus, short-term efforts can lay the path to long-term investing.

3. How have advancements in technology impacted intermarket analysis in recent years?

With technology, there are multiple tools at investors’ disposal. But data is the game changer. There is so much data to study and analyze, which can give a complete understanding of the market. Further, financial companies use artificial intelligence to establish relationships.