Understanding Intermarket relationships requires the
simultaneous analysis of 4 main asset classes: Currencies (U.S. Dollar remains most liquid of all major traded currencies), Commodities, Bonds
and Stocks. Synchronizing the rotation of asset allocation within your own portfolio lies in getting a grip on how these four markets interrelate
with each other.
– Click on the thumbnail (right) for a Summary of the key Directional Relationships between the 4 markets.
Commodities lead bonds, bonds lead stocks and stocks lead commodities. The cycle holds true at least in a normal inflationary/disinflationary environment. Other than itself, commodities affects 2 markets (bonds and stocks); effectively, impacting 3 out of the 4 intermarket relationships. Even if you do not trade Commodity ETFs as part of your portfolio, you need to track Commodities as a leading economic cycle indicator. The futures/Mini Futures that you see on news headlines/trading screens are relevant only as daily gauges for stock market behaviour. They are not a cycle indicator across Asset Classes.
So, you may already understand the criteria to define a "normal" economic cycle for the Directional Relationships to behave "ideally" (see below); BUT, how do you determine which Asset Class is driving the cycle? In other words, at a given point in the cycle, which Asset Class has the DOMINANT Relative Strength compared to the other asset classes?
The answer lies in the creative use of price-centric Point & Figure methodology.
The Business Cycle in Brief
Bonds lead stocks, to trend in the same direction – except during deflation when bonds rise and stocks fall. On average bonds are 18 months ahead of stocks in rising to their peak or falling to their bottoms; thereafter, stocks follow in the same direction. If bonds have not broken down yet, this extends the gains in the stock market, acting as support for prevailing stock market levels. The real risk begins to build 5-7 months after the bond market peaks or bottoms, thereafter the next 6 months stocks accelerate in the direction bonds have set.
Typically, commodities and bonds have an inverse relationship: as commodities rise, bonds falls but as commodities fall, bonds rise. Inflationary expectations affect bond prices. US Dollar movements which is tied into Monetary Policy changes affects commodity prices. Commodities lead bonds 12–18 months in advance (it takes this long for Monetary Policy to come into effect) and 24–27 months before the economy fully absorbs the policy changes.
Now, the relationship between commodities and stocks. Stocks tend to lead commodities. Commodities are a hedge against inflation, with price inflation and higher inflation expectations occurring towards the end of the business cycle.
Money and company growth using credit (loans) takes time to make its way through the economic system, from making prices rise to raising expectations on inflation. Thus, commodities usually outperform at the end of the business cycle.
Rising bond prices generally raise stock prices in recovery, with falling commodity prices confirming an economic expansion phase is in play. As the expansion matures and begins to decelerate, watch for bonds to turn down first (as interest rates rise), followed by stocks.
Finally, it is after commodities outperform stocks and start turning down, this signals the end of an economic expansion with the probable start of activity decelerating, then slipping into an impending recession.