Although our primary goal is to examine intermarket relationships between financial sectors, a lot of emphasis will be placed on the commodity markets. This is done for two reasons. First, we'll be using the commodity markets to demonstrate how relationships within one sector can be used as trading information. This should prove especially helpful to those who actually trade the commodity markets. The second, and more important, reason is based on my belief that commodity markets represent the least understood of the market sectors that make up the intermarket chain. For reasons that we'll explain later, the introduction of a futures contract on the CRB Index in mid-1986 put the final piece of the intermarket structure in place and helped launch the movement toward intermarket awareness.
The key to understanding the intermarket scenario lies in recognizing the often overlooked role that the commodity markets play. Those readers who are more involved with the financial markets, and who have not paid much attention to the commodity markets, need to learn more about that area. I'll spend some time, therefore, talking about relationships within the commodity markets themselves, and then place the commodity group as a whole into the intermarket structure. To perform the latter task, I'll be employing various commodity indexes, such as the CRB Index. However, an adequate understanding of the workings of the CRB Index involves monitoring the workings of certain key commodity sectors, such as the precious metals, energy, and grain markets.
KEY MARKET RELATIONSHIPS
These then are the primary intermarket relationships we'll be working on. We'll begin
in the commodity sector and work our way outward into the three other financial
sectors. We'll then extend our horizon to include international markets. The key
relationships are:
1. Action within commodity groups, such as the relationship of gold to platinum
or crude to heating oil.
2. Action between related commodity groups, such as that between the precious
metals and energy markets.
3. The relationship between the CRB Index and the various commodity groups and
markets.
4. The inverse relationship between commodities and bonds.
5. The positive relationship between bonds and the stock market.
6. The inverse relationship between the U.S. dollar and the various commodity
markets, in particular the gold market.
7. The relationship between various futures markets and related stock market
groups, for example, gold versus gold mining shares.
8. U.S. bonds and stocks versus overseas bond and stock markets.
THE STRUCTURE OF THIS BOOK
This chapter introduces the concept of intermarket technical analysis and provides
a general foundation for the more specific work to follow. In Chapter 2, the events
leading up to the 1987 stock market crash are used as the vehicle for providing an
intermarket overview of the relationships between the four market sectors. I'll show
how the activity in the commodity and bond markets gave ample warning that the
strength in the stock market going into the fall of that year was on very shaky ground.
hi Chapter 3 the crucial link between the CRB Index and the bond market, which is
the most important relationship in the intermarket picture, will be examined in more
depth. The real breakthrough in intermarket work comes with the recognition of how
commodity markets and bond prices are linked (see Figure 1.3).
Chapter 4 presents the positive relationship between bonds and stocks. More and more, stock market analysts are beginning to use bond price activity as an important indication of stock market strength. The link between commodities and the U.S. dollar will be treated in Chapter 5. Understanding how movements in the U.S. dollar affect the general commodity price level is helpful in understanding why a rising dollar is considered bearish for commodity markets and generally positive for bonds and stocks. In Chapter 6 the activity in the U.S. dollar will then be compared to interest rate futures.
Chapter 7 will delve into the world of commodities. Various commodity indexes will be compared for their predictive value and for their respective roles in influencing the direction of inflation and interest rates. The CRB Index will be examined closely, as will various commodity subindexes. Other popular commodity gauges, such as the Journal of Commerce and the Raw Industrial Indexes, will be studied. The relationship of commodity markets to the Producer Price Index and the Consumer Price Index will be treated along with an explanation of how the Federal Reserve Board uses commodity markets in its policy making.
The Dow Jones Utility Average is recognized as a leading indicator of the stock market. The Utilities are very sensitive to interest rate direction and hence the action in the bond market. Chapter 10 is devoted to consideration of how the relationship between bonds and commodities influence the Utility Average and the impact of that average on the stock market as a whole. I'll show in Chapter 11 how relative strength, or ratio analysis, can be used as an additional method of comparison between markets and sectors.
Chapter 12 discusses how ratio analysis can be employed in the asset allocation process and also makes the case for treating commodity markets as an asset class in the asset allocation formula. The business cycle provides the economic backdrop that determines whether the economy is in a period of expansion or contraction. The financial markets appear to go through a predictable, chronological sequence of peaks and troughs depending on the stage of the business cycle. The business cycle provides some economic rationale as to why the financial and commodity markets interact the way they do at certain times. We'll look at the business cycle in Chapter 13.
Chapter 14 will consider whether program trading is really a cause of stock market moves—or, as the evidence seems to indicate, whether program trading is itself an effect of events in other markets. Finally, I'll try to pull all of these relationships together in Chapter 15 to provide you with a comprehensive picture of how all of these intermarket relationships work. It's one thing to look at one or two key relationships; it's quite another to put the whole thing together in a way that it all makes sense. I should warn you before we begin that intermarket work doesn't make the work of an analyst any easier. In many ways, it makes our market analysis more difficult by forcing us to take much more information into consideration. As in any other market approach or technique, the messages being sent by the markets aren't always clear, and sometimes they appear to be in conflict. The most intimidating feature of intermarket analysis is that it forces us to take in so much more information and to move into areas that many of us, who have tended to specialize, have never ventured into before.
The way the world looks at the financial markets is rapidly changing. Instant communications and the trend toward globalization have tied all of the world markets together into one big jigsaw puzzle. Every market plays some role in that big puzzle. The information is there for the taking. The question is no longer whether or not we should take intermarket comparisons into consideration, but rather how soon we should begin.