Intermarket analysis refers to the conjunctional study of two or more broad classes of financial assets. Through intermarket analysis, analysts try to identify current economic conditions and make well informed investment decisions accordingly. The classes include stocks, bonds, commodities, and foreign exchange (currencies). This article will provide a brief introduction to intermarket analysis by presenting the strong correlated relationships between the different asset classes in various economic conditions.
The Business Cycle
The business cycle is the foundation of our discussion on this topic, as it defines the conditions of an economy with which we can relate to the asset classes and their correlations. The cycle measures the growth of an economy over time and consists of four stages which are, expansion, peak (or boom), contraction, and trough. It can be easily illustrated with the diagram below.
The general phase of an economy is expected to be expansionary however, excessive market optimism may lead to unnatural growth and hence an uncontrollable inflationary environment (referred to as hyperinflation) which can be disastrous. Therefore the business cycle is said to be irregular and unpredictable with no defined length of time for any of it’s phases. We will now look at the economic conditions in expansionary and contractionary environments, as these are the easiest to identify and determine the characteristics of the asset classes.
Economic Conditions in an Expansionary Economy
An economy experiencing an expansionary environment is referred to as a growing economy. Here businesses generally observe increasing revenues and profits which are translated to business expansion, as well as an increase in recruitment which decreases unemployment. Interest rates also increase since investors require a higher return on their investments due to increasing prices. An expansionary economy is typically explained with an increasing inflation rate and a decreasing unemployment rate.
Economic Conditions in a Contractionary Economy
In a contractionary economy businesses will experience a decrease in revenues and profits, which can lead to business consolidation and employee layoffs. Prices decrease as demand for normal goods and services decreases, which leads to decreasing interest rates. A contractionary economy is typically described by deflation or disinflation and increasing unemployment. This stage in the cycle can be referred to as a recession or a depression, depending on how severe the conditions are.
Now that we have an understanding of the economic conditions surrounding an economy, we can now study the behaviors of the asset classes with respect to their economic environment.
The chart above provides an excellent illustration of the intermarket relationships between the four major asset classes. If we assume an inflationary environment pre 1998 and a deflationary environment post 1998, we can observe the major relationships. The table below provides strong correlations between the asset classes.
As the table above shows, the only difference between an inflationary environment and a deflationary one, is the correlation between stocks and bonds. In an inflationary environment, a positive correlation between stocks and bonds, that is, when one increases, the other should also increase and vice versa.
Note that this may not always occur because they are not perfectly correlated (i.e. a correlation of 1). Interest rates will increase and will put a downward pressure on bonds, but upward forces will ultimately triumph due to a productive environment. In a deflationary environment, investors will generally switch to safer investments which will increase the price of bonds, and decrease stocks resulting in a change in their fundamental relationship.
To wrap up then, to fully understand the financial markets and the different asset classes and their intertwined relationships, it is essential to be able to take a step back and look at them from a global perspective, as well as domestic. Intermarket analysis can help to maximize utility, when considered over long to medium periods because of time lags. Hence, it should be used as a lagging indicator to verify major market movements.
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