Intermarket Analysis is a rather complex but useful practice for traders who intend to enrich their investment activity with objective evidence, providing guidance in the trade composition phase.
We discuss it here, explaining what intermarket analysis is, how it can help traders, and how to practice it effectively.
A Definition of Intermarket Analysis
As the name suggests,
intermarket analysis is the study of correlations between markets. It was introduced by legendary investor John Murphy in the 1980s and has since been part of the range of practices available to more experienced traders.
The purpose of intermarket analysis is to detect market correlations and use them to predict future trends. Obviously, the concept of
prediction in trading should be taken with a grain of salt. There is no practice capable of saying with certainty how an asset will move. At most, we talk about
probability and statistical evidence.
Some correlations between markets are well established. Here are the main ones.
- Stocks and Bonds. Traditionally, there is an inverse correlation between the stock market and the bond market. When bond yields rise (and bond prices fall), investors may prefer to shift their funds from the stock market, perceived as riskier, to bonds. This can lead to a decline in the stock market. Conversely, when bond yields fall, the stock market tends to rise as financing costs for companies decrease.
- Stocks and Commodities. An increase in commodity prices can be a signal of economic growth, as it indicates higher demand for goods. However, if the increase in commodity prices is too rapid, it could lead to inflationary pressures, forcing central banks to raise interest rates, which could have a negative effect on the stock market.
- Currencies of Exporting Countries and Commodities. The currencies of nations that export large quantities of commodities, such as the Canadian and Australian dollars, tend to be strongly correlated with commodity prices. An increase in commodity prices can strengthen these currencies, while a decrease can weaken them.
What Intermarket Analysis Allows You to Do
Basically, and especially if done well, intermarket analysis allows you to...
- Confirm Trends. Before entering a position, you could employ intermarket analysis to confirm your predictions. For example, if you think the stock market is about to decline, you could check if there are similar signals in the bond or commodity markets as well.
- Anticipate Reversals. Reversals in one of the interconnected markets can often foreshadow reversals in the others. At the same time, if you notice a divergence between two usually correlated markets (e.g., stocks continue to rise while bond yields begin to fall), this could indicate an impending change.
- Risk Management. Intermarket analysis helps reduce risk. Those who have a long position in one market could hedge by taking a short position in an inversely correlated market.
The Limitations of Intermarket Analysis
Intermarket analysis is useful but far from perfect. No tool, be it analytical, operational, or strategic, is. Therefore, it's also interesting to investigate the
limitations of intermarket analysis. Here's an overview.
- Randomness of Correlations. The relationships between markets are not static. Rather, they can change over time. Economic events, monetary policies, and global crises can drastically alter correlations considered "historical," making intermarket analysis less reliable, especially in particular and chaotic market conditions.
- Influence of External Factors. Unforeseen factors such as geopolitical crises, natural disasters, or political events can cause sudden and unexpected movements in markets, effectively disproving traditional correlations. Such events can make intermarket analysis less effective in predicting market movements.
- Market Synchronization. During periods of financial crisis or high global volatility, markets may move in sync, reducing the effectiveness of traditional correlations. In these cases, markets that usually move inversely may behave in the same way, complicating predictions based on intermarket analysis.
- Difficulty of Interpretation. Intermarket analysis requires a deep understanding of global economic dynamics and the interrelationships between various markets. For less experienced traders, it can be difficult to correctly interpret the signals coming from different markets. This increases the risk of making wrong decisions or, even worse, falling into overtrading. In this case, the apparent correlations are "abused," entering a vicious circle.
These limitations suggest a small but great truth: intermarket analysis is a complementary tool, rather than an autonomous and "stand-alone" tool.
