Intermarket analysis is a branch of technical analysis that examines the correlations between a number of related markets, which may include major asset classes such as stocks, bonds, commodities and currencies. It can be thought of as a type of instantaneous fundamental analysis that gives you an overall bias and direction for the markets you are studying.
Equities markets have been difficult this year and intermarket analysis can give you an insight into what you can expect in the near-term.
In intermarket analysis you look for times when the underlying relationships are diverging for warning of a turnaround, or when they are moving in the same direction for a confirmation of the underlying trends. John Murphy’s first book, Intermarket Technical Analysis, provides an excellent in-depth study of the correlations between related markets.
Crude-Oil As a Barometer On the Economy
Crude-oil prices are a good indication of the state of the underlying economy. Higher prices cannot be supported for any length of time unless the underlying economy is exhibiting strength.
Crude-oil is one of a raft of commodities that has suffered severe selling in the past few months, down over 30% since its mid-March peak. At the end of June it hit 8-month lows, but has now rebounded a whopping 13% and is at a 1-month high.
There are a number of reasons for the recent price surge, including speculation that central banks from Europe to China will ease monetary policy to spur economic growth while sanctions against Iran may curb supply. The European Central Bank has this week cut interest rates to 0.75%, and the Chinese central bank has now cut interest rates for a second time in a month.
Crude-oil prices provide an insight into the underlying strength of the economy and can be used in intermarket analysis to determine what to expect in the equities market.
Intermarket Analysis – Crude-Oil Versus S&P500
One way to anticipate near-term activity in the equities markets is to examine the S&P 500 equities index and compare it against the movements and trend in the crude-oil market.
The interrelationship between equities and crude-oil comes from the fact that energy costs make up a significant proportion of the costs of doing business for the corporate world. When crude-oil prices are high, energy costs are seen as a drag on corporate activity and a tax on doing business. Crude-oil prices also impact on consumer spending which equates to over 65% of growth in the US economy.
2009-2010 – Crude-Oil Versus S&P500
Our analysis starts back in 2009. S&P500 equities and crude-oil prices suffered a severe down trend in the aftermath of the GFC. At the end of 2008 crude-oil prices based and a new uptrend began in March 2009 (as shown in Chart 1 below). The crude-oil price led the rebound in the S&P500 equities market and the divergence provided a fantastic setup for the bull run in S&P500 equities which began in April 2009.
The uptrends in crude-oil and the S&P500 equities market continued through until early 2010, when crude-oil again gave a great divergence signal that there was impending weakness in the S&P500 equities market. The equities market sold-off in April 2010, but the crude-oil market was giving warning signals of weakness in the overall economy from earlier in 2010, as crude-oil prices failed to make new highs (in direct contrast to the equity prices).
S&P500 equities remained in a downtrend until 4Q 2010, when again we saw divergence between crude-oil and equity prices, as crude-oil began to make new highs and the equities prices continued lower.
2010-2012 – Crude-Oil Versus S&P500
By October 2010 crude-oil started its uptrend and the S&P500 equities soon followed (as seen in Chart 2 below).
The uptrends in crude-oil and S&P500 equities remained intact until April 2011, when divergence reappeared, as crude-oil gave a warning of weakness and started to make lower lows. It took another three months for the S&P500 equities market to crash, which began in May 2011 and we saw follow-through in July 2011.
By the 4Q 2011 crude-oil prices began to find a bottom and again there was a divergence signal, which was an early sign that the underlying economy was strengthening and supporting higher oil prices.
The uptrends in crude-oil and S&P500 equities remained intact again until April 2012, and once again divergence appeared as crude-oil gave an early warning of weakness with lower lows. Again it took a couple of months for the S&P500 equities market to crash, which it did in April 2012.
Crude-oil has been a leading indicator for the S&P500 equities markets for the past four years and any divergence should be heeded as an early warning signal for equities prices.
Currently there is still a divergence between the crude-oil and S&P500 equities prices. Chart 2 illustrates that crude-oil prices are confirming underlying weakness in the overall economy, but equities prices are still ticking higher (defying gravity perhaps).
We would need to see crude-oil have consecutive weekly closes above $US92 to confirm a change in trend for crude-oil. Unless this occurs in the near-term there is underlying weakness in the economy which will translate to lower equity prices.
This outcome may be short circuited by a coordinated global central bank intervention towards quantitative easing, but until that occurs be prepared for weaker equity prices in the near–term.
Investment Adviser D2MX Trading
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.