There is probably nary a bond trader that does not have a chart of the S&P 500 futures up on his or her computer screen. Why? It is very simple. Markets are interconnected. Typically, what is good for stocks is bad for bonds. What is bad for U.S. equities is rarely ever good for German stocks. What is good for gold is bad for the dollar. Understanding these relationships and how you can use them in your trading and investing is very important.

John Murphy wrote an entire book on the subject: Intermarket Technical Analysis. Normally, I would urge you to purchase it right away. However, he is currently working on a new edition, so you might want to wait until that comes out. In the meantime, if you have the book that I wrote a chapter in a few years back, New Thinking in Technical Analysis: Trading Models from the Masters, you will find a chapter on the subject by Murphy. I also discuss using intermarket technical analysis in conjunction with Elliott Wave Theory in that book, as well as in my most recent book -- Applying Elliott Wave Theory Profitably.

OKAY, GET ME STARTED. WHAT ARE SOME OF THE BASIC RELATIONSHIPS?

Bonds versus stocks: This is supposed to be one of the most basic relationships. Much analysis suggests that what is good for stocks is bad for bonds, and vice-versa. Why? Stocks typically act well when the economy is improving, as expectations for increased profits will tend to drive equity valuations higher. At the same time, the U.S. central bank's (the Federal Reserve, or Fed) main job is to control inflation (that's right, it's job is NOT to ensure low unemployment and growth in U.S. output -- it's to keep inflation in check). If the economy is improving, then at some point bondholders will assume that the Fed will raise interest rates to prevent inflation from getting out of hand. This means that as stocks rise, interest rates generally rise as well. Interests rates, mathematically, must move in the opposite direction of bond prices. Therefore, as stock prices rise (along with interest rates), bond prices usually fall.

Of course, this is not always the case. There are times when both stocks and bonds decline together. For example, very high inflation is not good for stocks. It can slow the economy and hurt investment (when interest rates rise to extremely high levels, it makes it too costly to borrow money). Ultimately, high interest rates will slow the economy and will take the wind out of the stock market's sales.

Another situation (you may have seen this mentioned recently in the news) that could theoretically hurt both stocks and bonds would be a sharp drop in the value of the U.S. dollar. Why? Because many foreigners own a heck of a lot of U.S. dollar denominated bonds, as well as U.S. equities. As you may recall from my article on the MSCI Japan iShares (see our ETF Authority issue from July 7, 2003), a weak dollar helps U.S.-based investors that own foreign shares. From the perspective of foreign investors, however, a weak dollar hurts owners of dollar denominated stocks and bonds (it lowers the value of these securities when they are converted back into an investor's home currency). Therefore, a sharp drop in the dollar could cause foreign investors to dump their U.S. stocks and bonds, resulting a decline for both markets. Likewise, a very strong dollar could cause both stocks and bonds to rise in tandem. That was the general trend for much of the 1990s.

Please note that the dollar was much weaker than it is right now back in 1995, and there was no major sell-off in U.S. stocks at that time (though the bond market had a terrible time of it in 1994, and the dollar fell for a good part of that year too). Also, as stocks tanked in 2000-2001, the dollar held its own. It is very tough to tell which comes first, weak stocks/bonds or a weak dollar. I tend to believe that weak asset markets will hurt a currency. However, you can then get a very negative feedback loop that could take the dollar, as well as U.S. stocks and bonds, sharply lower. While this has rarely been seen in the U.S., that kind of trading action has taken place in some emerging markets (remember the sell-off in the Asian markets in 1997?).

The dollar versus commodities: This is usually expressed as "what is good for gold is bad for the dollar." The reason why this is often the case is very simple. If there is no reason to believe that gold should change in its external value (that is, its value to people outside of the United States), then it should move opposite the value of the U.S. dollar. This is because almost all commodities are paid for in U.S. dollars. So, if the dollar weakens, and if gold (or oil, or wheat) does not rise in price, then non-U.S. dollar-based accounts will be able to purchase those commodities relatively cheaply. Of course, this does not really address the economic importance of the commodities, nor does it consider where the supply of the product and demand for the product come from. It is just one part of the equation, but can override other factors for short periods of time.

Inflation is also supposed to be bad for a currency, as it makes imported goods relatively more expensive. The U.S. imports far more than it exports, so high inflation will tend to weaken the dollar (more dollar sales) and raise the price of commodities to U.S. dollar-based users of these commodities.

The bond market and commodities: Inflation is bad for the bond market. Many analysts look to the commodity markets for a leading indication of the direction of inflation. If commodity prices trade higher, then the market will start to look for inflation, which leads to higher interest rates and lower bond market prices.

ARE THERE ANY OTHER PLACES TO LOOK FOR INTERMARKET WORK?
Absolutely. If you trade precious metals, then you can often find leading and lagging indications among gold, silver and platinum. Gold stocks also may lead turns in the price of gold. Elsewhere, you can look at different stages of production in the energy sector for help with your stock or energy futures trading.

Essentially, anyplace where there is a fundamental connection among stocks or other assets, you can perform intermarket research. For example, if International Paper (IP, $38.32) announces that sales of corrugated boxes are improving, then you might want to look into buying stock in major users of such products. One example would be a company like Amazon.com (AMZN, $58.06), which packages the retail products it sells in those boxes. Other plays might include shipping companies like UPS (UPS, $66.03), which would become a recipient of consumer largesse. For that matter, such action might also bode well for advertisers too (watch to see if IP announces increases in sales of newsprint and catalog paper).

CAN I USE THIS INFORMATION TO TRADE?
The answer is yes, sort of. Day traders can sit and watch the stock and bond markets and make trading decisions based on those interactions all day long. Sometimes stocks lead. Sometimes bonds lead. Sometimes they move together. Sometimes they move in opposite directions. As long as you recognize the current regime, you can trade off the relationships fairly easily. In this day and age of tight spreads and low commissions, this is a legitimate tool to use.

As for the bigger-picture ideas noted above, it's probably not a good idea to use these relationships (between bonds/stocks, bonds/commodities, etc...) as an exclusive basis for specific longer-term trading decisions, as relationships can vary substantially over time. Look at the CRB and 10-Year T-Note chart I showed earlier. Sometimes the two markets turned in tandem, other times bonds led and sometimes the CRB led. So, using one to trade another can be very difficult.

However, when you are doing your analysis, I cannot underestimate the importance of this kind of research. There are relationships that typically hold, as I've noted in the past. There have been many times when I would have, for example, a very bullish expectation in the stock market, but my charts would show a huge rally in bonds. If I have stronger faith in my bond market expectation, then I should probably lower my stock market estimates, since huge equity market rallies rarely coincide with sharp gains in bonds.

Similarly, if your analysis shows strong gains in the Nasdaq-100 Trust (QQQ, $35.01), but losses in the Semiconductor HOLDR (SMH, $38.35), then you probably need to rethink one of those forecasts.

SUMMARY
Intermarket analysis can provide you with important clues as to the overall direction of the stock market. Understanding the fundamental relationships among various industries, as well as between various asset classes, can help you to keep your trading and investing on target. However, intermarket work is rarely helpful for swing trades. Still, daytraders can make money at times off the give and take between the bond and stock markets.

Good trading!

Steven Poser
Editor
The ETF Authority
New York, NY