Redefining Intermarket Analysis

Humans have a reason for everything. Victor Niederhoffer’s famous 17% exercise regarding breaking news is a historical validation for naive reasonings.
When it comes to broad market movement many fundamentalists and market technicians are in consensus. Most of them may agree that gold is a crisis commodity and rises as it becomes an asset of last resorts, a real global currency. But there are things even consensus can’t solve. Like now, despite the number of gold bulls there is limited literature on whether gold going up is inflationary or deflationary. Even market technicians as a group cannot reach a consensus whether the times are inflationary or deflationary. The point I am making here is that bounded rationality is for everyone, whether one is looking at demand-supply data or market patterns. Our knowledge will always be limited.
Divergence…On one side the group of experts agree that commodities move up together but there are not enough reasons to explain why Oil and Gold diverged by 64%(July – Dec 2008) though they both belong to the same asset class. Divergence is not only a reason to challenge efficient theorists, it’s also a nemesis for technicians. To be able to pinpoint that precious metals index (AIGP) would continue to outperform Industrial metals (AIGI) by 48% (Feb 2008- Feb 2009) was a hard task.
On a hindsight basis things may look explainable, but anticipation is the real challenge. And we are not talking about anticipating one asset movement here. We are talking about a system that could overview commodities, bonds, forex, equity at the same time. Elliotticians tag, ‘we are here’ by drawing a fractal led contour of a wave structure. They count it, label it and point ‘we are going here’ in 2012.
Even Elliotticians despite such sharpness lack the command on Intermarket picture. If one is so focused on reading the market pattern, it may be tough also reading the macro time picture. How can we build an integrated model to read where the commodities, currencies, bonds and equity are headed? This system will lack the micro sharpness of targets, but it does compliment the micro with macro. A valuable input indeed.
Intermarket solution… John Murphy’s seminal work on Intermarket Analysis made the first attempt to balance the macro with micro. The subject illustrates linkages between assets and goes about systematically explaining the four asset class viz. commodities, bonds, forex and equity. The books lays down clear guidelines like the dollar trends in opposite direction of commodities, commodities trend in opposite direction of the bonds, bond prices normally head in the same direction as stock prices, during a deflation (which is rare) bond prices rise while stocks fall. This large revolutionary discourse was published in 1991.
Thanks to Murphy, Intermarket is a widely understood subject. However, there are few unanswered questions? Though Murphy illustrates a repeating cycle of performance between the broad 4 assets, why does he call the study Intermarket analysis and not Intermarket cycles? Intermarket can’t explain large divergences (>50%) between similar sector assets like gold or oil, technology and blue chips or between two bond prices. Whenever a traditional relationship fails like between gold and dollar and both top assets start moving together Murphy calls it a failure of Intermarket behavior. Are markets not supposed to do what they are doing? Can Intermarket failure be explained?
We decided to understand Intermarket failure. We took 55 assets from the following asset classes; metals, energy, agro, bonds, currency, equity, and benchmarked all of them against Dollar Index. The integrated database was ranked on price performance for quarterly trends. We indexed the assets to a common base value trying to understand change in growth. We assumed intermarket analysis was about Intermarket cycles, so ranking process or relative ranking should work cyclically. Ranking a global portfolio over a quarterly performance illustrated extremes. This made the process of understanding Intermarket linkages better. Extremes by nature were unsustainable and the very fact that an asset reached the top of its group proved that it was time for divergence to correct. Performance was cyclical. It was as simple as that. A simple ranking on price performance suggested which of the assets might diverge, when they will fail their conventional Intermarket behavior and the broad outlook of the market in terms of top four assets for the next quarter.
Japanese Yen was the top-ranked and Euro was the worst. Carbon Emissions ETF was the best and Crude Oil the worst. Precious metals and Gold were the best and Zinc was the worst. In Agro, Coffee was the best and Livestock the worst. In thematic equity and selected global equity indices, shipping sector was the best and agricultural based equity the worst. Strategy of going long (over allocation) on the worst and short (under allocation) was the suggested ranking strategy. Crude Oil despite absolute price change (negative or positive) should outperform carbon emissions ETF.
To understand more about broad assets we aggregated the various sectors. Agro was the top performer, and thematic equity was the worst. Nine currencies against dollar suggested dollar weakness in weeks ahead and metals and energy suggested further downside but bottoming structure. And of all this was for one quarterly cycle.