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John Murphy and Martin Pring offer some great insights and references for those interested in intermarket analysis. Both incorporate economic considerations as part of a flow that allows investors to properly apply leading indicators into their analysis while using lagging indicators to confirm that analysis. Although the timing of leading and lagging markets and economic metrics vary, monitoring relative strength of markets can provide another tool for the technician.

To gain a sense of the theoretical flow of the markets, Table 1 provides a quick summary of those identified by John Murphy in the text, Intermarket Analysis: Profiting from Global Market Relationship. It is taken from my July 20, 2006 "Analytical Toolbox" article on the same subject.

Table 1: John Murphy's Intermarket Flows Starting with the US Dollar

Clearly Mr. Murphy provides more detailed, real-world applications of intermarket relationships in his texts on the subject, but the logical order in Table 1 should provide a compelling case for periodically assessing the markets together rather than in isolation.

When monitoring conditions the analyst is confronted with varying lag times for these different cause-effect reactions to take hold. In addition, there can be shorter duration changes through the markets which can make the approach more challenging. An approach used by Martin Pring that assesses these flows in relation to the business cycle can help in that regard.

Mr. Pring breaks the business cycle into six phases according to the action observed for three primary asset classes: stocks, bonds & commodities. In his book, Technical Analysis Explained, he notes these phases as follow in Table 2. This view helps underscore the nature of rotations and flows. While there are times the different asset classes move in opposite directions, all three can and do spend periods trending together.

Table 2: Martin Pring's Asset Class Movement During the Business Cycle

Assuming asset price trend changes lead the business cycle, be careful of reacting too strongly to one piece of economic data. Granted the market may be reacting, requiring you to manage your risk accordingly. The point is, don't assume the cause of the move is anything more than noise from short-term traders adjusting their bets. In other words, look to the different markets as a primary point of reference for the move versus explanations that follow.

Current Trends

Using exchange-traded funds [ETFs] that are well correlated to different asset classes as proxies for these asset classes, Figures 1-5 provide a current view of market trends. The 40-week exponential moving average [EMA] is used as an objective tool to define the long-term trend. In addition, relative ratios (also referred to as relative strength comparisons-RSC) are added below the chart to help identify stronger asset classes on a relative basis. Core technical tools can be used to assess RSC lines, including trendlines, support and resistance.

Table 3 displays the ETFs used as proxies, along with their related markets and corresponding two year daily return correlation values.

*exchange-trade note [ETN]

Table 3: ETF Proxies with Asset Class, Index & Correlations

The bond correlations are negative since the ETF reflects bond prices while the index reflects bond rates. With the exception of the 3-7 year treasuries, return correlations reflect very strong relationships between the ETF and index, making them a reasonable proxy. IEI maintains simply a strong relationship with an R2 value of 0.79.

Charts for ETFs with the strongest correlations follow. Table 4 provides the long-term trend for each ETF as determined by the direction of its 40-week EMA. The RSC lines use the asset class that follows it in the Murphy flow (i.e. GLD is used for UUP).

 

Figure 1: USD Weekly Line Chart with GLD RSC




Figure 2: GLD Weekly Line Chart with DBC RSC


 

Figure 3: DBC Weekly Line Chart with TLT RSC


 

Figure 4: TLT Weekly Line Chart SPY GLD RSC

Figure 5: SPY Weekly Line Chart with UUP RSC

Table 4: Asset Classes Trend and Relative Strength

It appears that some trends and relative strength are transitioning from a longer-term perspective. More next week.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.

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