Chapter 9 - Intermarket Analysis

Question 1

Clarify common confusion on bond pricing.

Answer 1

What causes bond prices to fall? Bond prices move in inverse fashion to interest rates, reflecting an important bond investing consideration known as interest rate risk. If bond yields decline, the value of bonds already on the market move higher. If bond yields rise, existing bonds lose value.

Question 2

What is the discount rate?

Answer 2

The rate at which banks can borrow directly from the Fed.

Question 3

What is disinflation?

Answer 3

A slowing of the inflation rate.

Question 4

What is the federal (fed) funds rate?

Answer 4

The fed funds rate is the interest rate at which banks lend to one another.

Question 5

What is the difference between the federal funds rate and the discount rate?

Answer 5

The fed funds rate is the interest rate at which banks lend to one another. The discount rate is the rate at which the central bank lends to banks as a lender of last resort. The Federal Reserve sets both rates.

Question 6

What is intermarket analysis?

Answer 6

The study of the linking and relationships
among financial and non-financial markets,
both domestic and global. Its basic premise
is that all markets move together and not in
a vacuum.

Question 7

What is the business cycle?

Answer 7

Often referred to as the economic cycle, it
represents the normal expansion and
eventual contraction pattern of the
economy and generally lasts four years.

Question 8

What is intermarket analysis?

Answer 8

• Intermarket analysis is the study of the linking and relationships among financial and
  non-financial markets, both domestic and global, through technical analysis. There are
  four main financial market groups: commodities, bonds, currencies and equities.

Question 9

What are the seven key primary market relationships within intermarket analysis?

Answer 9

– Th e relationship within commodity groups, such as gold to silver and platinum or
oil to gas.
– Th e relationship between related commodity groups, such as energy markets to
precious metals.
– Th e relationship between the CRB Index and the different commodity groups and
markets.
– Th e inverse relationship between bonds (bond prices) and commodities.
– Th e parallel relationship between the stock market and bond prices.
– Th e relationship between the various commodity groups and their related stock
sector (i.e., oil and oil stocks).
– Th e relationship between U.S. bonds and stocks and international bonds and
stocks.

Question 10

Within the primary market relationships lie the sixteen principles of intermarket analysis. What are they?

Answer 10

– The four main groups are commodities, bonds, currencies and equities.
– Th e U.S. dollar usually trends in the opposite direction of the CRB Index and
Gold.
– A falling U.S. dollar is normally inflationary; a rising dollar is normally
non-inflationary.
– Gold leads the commodities (CRB Index).
– Th e CRB Index normally leads and moves in the same direction as bond yields and
in the opposite direction of bonds.
– A rising CRB Index is normally inflationary and a falling Index is deflationary.
– Bonds normally lead and move in the same direction as stock markets.
– A falling bond market is normally bearish for equities; a rising bond market is
normally bullish for equities.
– The Dow Utilities Index normally follows the bond market and leads the stock
market.
– The U.S. stock and bond markets are linked to the major global markets.
– Certain stock groups (auto manufacturing, savings and loans, security brokerage
firms and interest sensitive stocks) normally lead the stock market.
– Gold and oil stocks normally lead the direction of inflation.
– All markets are interrelated and none move in isolation.
– During a deflationary period (which is quite rare), equities fall while bond
prices rise.
– A rising U.S. dollar is good for U.S. bonds and equities.
– A weak U.S. dollar favours large multinational corporations (i.e., those with
international sales exposure).

Question 11

Why is it important to take a global view of intermarket analysis?

Answer 11

• All financial markets are linked and affect each other since capital flows freely around
  the world to where opportunities are.

Question 12

What are the stages of a business cycle and the average growth and contraction phases?

Answer 12

• Recession is defined as a decline in the real GDP that occurs for at least two or more
  quarters.
• Low point, or depression, is the point in the cycle where there are high unemployment
  rates, a decline in annual income, overproduction and rising inventory levels. The
  length of time the cycle remains at this low point varies from weeks to sometimes many
  months.
• Expansion and recovery occurs when real GDP grows and there is a recovery from
  recession. This stage of the cycle usually lasts longest.
• Peak is highest point of the business cycle, where real GDP stops increasing and begins
  declining. Like a depression, a peak can last either a short or long time (which is
  considered prosperity).

Question 13

Why does the business cycle lag the stock market?

Answer 13

• The stock market cycle leads the Business Cycle by about 6-9 months because the
  market moves based on the anticipation of the economic activity and tries to forecast
  future fundamental events.

Question 14

Why is the role of the Fed important with respect to the business cycle?

Answer 14

• The goal of the Federal Reserve is to promote sustainable economic growth and
  employment along with stable prices. It attempts to smooth out the peaks and valleys
  by controlling the money supply through interest rate policy, which directly affects
  the cost of borrowing for both businesses and individuals. While the Fed can inject
  liquidity in an attempt to stimulate the economy, this can lead to inflation if continued
  for a long time.

Question 15

Explain the basic equity sector rotation model.

Answer 15

REFER TO YOUR DIAGRAMS!

Question 16

Which equity sectors lead and which lag during a business cycle?

Answer 16

• Consumer cyclicals, financials and transportation are generally the first sectors to
  advance and lead the beginning of a recovery, whereas basic industry and energy are the
  last. Note that the consumer non-cyclical and health care sectors gain strength as the
  business cycle nears its peak.

Question 17

How do equity sectors react in inflationary and disinflationary environments?

Answer 17

• An inflationary environment favors the precious metals (gold) and natural resource-
  related sectors. A disinflationary environment favors the financial, basic industry,
  technology, consumer cyclical, capital goods and utilities sectors.

Question 18

Identify the methodologies for building an intermarket-based portfolio.

Answer 18

• Intermarket analysis is a top-down process that begins with an examination of the four
  main markets to discover their current relationships to each other.
• This broader picture serves as a foundation for additional analysis within these four
  markets. The investor then steps down from the four markets to indexes, sectors and
  finally stocks or exchange-traded funds (ETFs) to invest in.

Question 19

Why are ETFs an excellent investment vehicle when building an intermarket-based portfolio?

Answer 19

• ETFs represent much broader and diverse areas than individual stocks. Currencies,
  commodities, bonds, stocks, indexes and sectors can all be traded through ETFs,
  whereas through individual stocks they are either not available or far more challenging
  to participate in.
• ETFs offer the opportunity to look for investing prospects upstream from the end
  analyses of individual securities.
• ETFs also allow investors to buy or sell an entire market or sector in one security.
• Through ETFs, an investor can buy commodities as easily as buying individual stocks.
  Investing in commodity ETFs also offers diversification into non-equity market related
  securities.

Question 20

Identify potential risk mitigation strategies.

Answer 20

• Risk can be minimized through diversification. Several standard methods to diversify
  a portfolio are listed; some or all of these can be implemented in an intermarket-based
  portfolio:
  – by type of security (bonds, preferreds and common stock)—or an ETF-driven
  portfolio, currencies, bonds, commodities, indexes and sectors can all be used;
  – by type of industry (i.e., paper-based or tangible-based);
  – by type of industry classified by the business cycle;
  – by degree of risk (high P/E, low P/E, high dividend, low dividend); and
  – by geography of operation (i.e., Asia, Latin American, North America, etc.).
• Another method of managing risk within a portfolio is by employing inverse or bear
  ETFs, which are normally leveraged and move in the opposite direction from the
  underlying sector or index.

Question 21

Describe the 8-step process of building an intermarket-based portfolio.

Answer 21

– Identify the direction of global markets and related indexes.
– Examine the four-year business cycle. What stage is the market in: expansion or
contraction?
– Asset allocation. Should the portfolio be weighted toward bonds or commodities?
Apply long-term relative strength review of bonds and commodities (CRB).
– Sector rotation. This confirms step 2. What sectors have the highest relative
strength? What sectors are declining or advancing now?
– Identify the strongest sectors through relative strength analysis.
– Identify the strongest performing ETFs or companies from the best performing
sectors.
– Establish targets and stops.
– Repeat steps 1-7 weekly or monthly, depending on investment time frame, to
maintain the best performing ETFs or stocks within a portfolio.

Question 22

Explain the difference between top-down and bottom-up analysis.

Answer 22

Each approach can be quite simple — the top-down approach goes from the general to the specific, and the bottom-up approach begins at the specific and moves to the general. These methods are possible approaches for a wide range of endeavors, such as goal setting, budgeting, and forecasting.

Question 23

What are ETFs?

Answer 23

ETFs or “exchange-traded funds” are exactly as the name implies: funds that trade on exchanges, generally tracking a specific index. When you invest in an ETF, you get a bundle of assets you can buy and sell during market hours—potentially lowering your risk and exposure, while helping to diversify your portfolio.

Question 24

What is the CRB index?

Answer 24

The Commodity Research Bureau Index, originally launched in 1957 and now managed by the CRB, is a price-weighted index that tracks the performance of a diverse basket of commodities, including energy, agriculture, metals, and livestock.

Question 25

TRUE or FALSE: A currency is worth what it can earn.

Answer 25

TRUE! In some ways, the value of money is simple to understand. Since money is just a medium of exchange, it’s worth whatever you can exchange it for. In other words, money is worth what it will buy. Given economic factors like inflation, interest rates, and others, money’s value can also be complex.

Question 26

Describe the basic framework of intermarket analysis.

Answer 26

1. All markets are interrelated and do not move in isolation.
2. Intermarket study uses external versus internal data.
3. Technical analysis is the favoured method of study.
4. Important emphasis is placed on the commodities market.
5. Intermarket research provides significant background data, not primary data.

Question 27

What are the seven key primary relationships within intermarket analysis?

Answer 27

1. A relationship within commodity groups, such as gold to silver and platinum, or oil to gas
2. A relationship between related commodity groups, such as energy markets to precious
   metals
3. A relationship between the CRB Index1 and the different commodity groups and markets
4. An inverse relationship between bonds (bond prices) and commodities
5. A parallel relationship between the stock market and bond prices
6. A relationship between the various commodity groups and their related stock sector (i.e., oil
   and oil stocks)
7. A relationship between U.S. bonds and stocks and international bonds and stocks

Question 28

What are the sixteen principles of intermarket analysis?

Answer 28

1. Th e four main groups are commodities, bonds, currencies and equities.
2. Th e U.S. dollar usually trends in the opposite direction of the CRB Index and Gold.
3. A falling U.S. dollar is normally inflationary; a rising dollar is normally non-inflationary.
4. Gold leads the commodities (CRB Index), as shown in Figure 9.5.
5. Th e CRB Index normally leads and moves in the same direction as bond yields, and in the
   opposite direction of bonds.
6. A rising CRB Index is normally inflationary; a falling CRB Index is deflationary.
7. Bonds normally lead and move in the same direction as stock markets (see Figure 9.6).
8. A falling bond market is normally bearish for equities;,a rising bond market is normally
   bullish for equities.
9. Th e Dow Utilities Index normally follows the bond market and leads the stock market.
10. U.S. stock and bond markets are linked to the major global markets.
11. Certain stock groups (auto manufacturing, savings and loans, security brokerage firms and
    interest sensitive stocks) normally lead the stock market.
12. Gold and oil stocks normally lead the direction of inflation.
13. All markets are interrelated and none move in isolation.
14. During a deflationary period (which is quite rare), equities fall while bond prices rise.
15. A rising U.S. dollar is good for U.S. bonds and equities.
16. A weak U.S. dollar favours large multinational corporations (i.e., those with international
    sales exposure), as shown in Figure 9.7.

Question 29

Describe the stages of the business cycle.

Answer 29

1. Recession
   Recession is defined as a decline in the real GDP that occurs for at least two or more
   quarters. Recessions feed on themselves. During a recession, consumers and businesses
   spend less. Because sales are failing, businesses reduce their spending, lay off workers, buy
   less merchandise and postpone plans to expand. When this happens, business suppliers do
   what they can to protect themselves as well. They too lay off workers and reduce spending.
   As workers earn less, they spend less, and business income and profits continue to decline
   while the recession continues. Businesses spend even less than before and lay off even more
   workers as the economy continues to contract.
2. Low point or depression
   Th is is the point in the economic cycle, characterized by high unemployment rates, a decline
   in annual income, overproduction and rising inventory levels. Eventually, real GDP stops
   its decline and starts expanding again. This is the lowest point in the business cycle. The
   amount of time the cycle remains at this low point varies from weeks to months, many
   months in some cases. During some depressions, such as the one in the 1930s, the low point
   can last years (although very rare).
3. Expansion and recovery
   At this stage of the business cycle, real GDP grows and there is a recovery from the
   recession. When business profits begin to improve, firms hire some workers and increase
   their orders of materials from their suppliers. Increased orders lead other firms to increase
   production and rehire workers. More employment leads to more consumer spending and
   further business activity, which in turn creates more jobs. Economists describe this upturn
   in the business cycle as a period of expansion and recovery, and this stage of the cycle usually
   lasts the longest.
4. Peak
   Th is is the highest point of the business cycle. Real GDP stops increasing and begins
   declining. At the top, or peak, business expansion ends its upward climb. Employment,
   consumer spending and production reach their highest levels. Like a depression, a peak can
   last either a short while or a long time (which becomes a period of prosperity).
   One of the dangers of peak periods is inflation. During periods of inflation, prices rise
   and the value of money declines. Inflation is more of a threat during peak periods because
   employment and earnings are at high levels. With more money, people are willing to spend
   more than before, leading to increased demand and rising prices.

Question 30

What questions should you ask yourself when tracking the business cycle?

Answer 30

1. In what phase of the business cycle is the economy at the present time?
2. Where is the business cycle heading?

Question 31

What are the five causes of the business cycle?

Answer 31

1. The first cause is changes in capital expenditures. When the economy is strong, businesses
   have expectations of sales growth and invest heavily in capital goods. After a period of time,
   businesses decide they have expanded to their limit, so they begin to decrease their capital
   investments and cause an eventual recession.
2. The second cause of the business cycle is inventory adjustments. At the first signs of an
   economy reaching its peak, some businesses cut back their inventories and then rebuild
   them at the first signs of a trough. Either action causes the real GDP to fluctuate.
3. Innovation and imitation are the third cause of the business cycle. Innovations include new
   products, new inventions or a new way of performing a task. When a business innovates,
   it often gains an edge on its competitors because its costs decrease or its sales increase,
   resulting in profits increasing and the business growing. Other businesses in the same
   industry wanting to keep up copy what the innovator has done (imitation) or come up
   with something better. Imitation companies usually invest heavily and an investment boom
   follows. Once the innovation spreads to another industry, the situation changes. Further
   investments are unnecessary and economic activity may slow.
4. Th e fourth cause of the business cycle is the credit and loan policies of commercial
   banking. When «easy money» policies are in effect, interest rates are low and loans are easily
   obtainable. They encourage the private sector to borrow and invest, thus stimulating the
   economy. However, eventually the increased demand for loans causes the interest rates to
   rise, which discourages new borrowers. As borrowing and spending slow down, the level of
   economic activity declines and keeps declining until interest rates fall and the business cycle
   begins over again.
5. Th e fifth and final cause of the business cycle is external shocks. Shocks such as increases in
   oil prices, wars and international conflicts, have the potential to either drive the economy
   up or drive it down. The economy may benefit when a new supply of natural resources
   is discovered. Such was the case with Great Britain in the 1970s when an oil field was
   discovered off its coast in the North Sea. The British economy, of course, profited since
   world oil prices were at an all time high, while the high prices hurt the United States.

Question 32

What questions should you ask yourself when examining the business cycle and relative stock market performance?

Answer 32

1. Will the historic pattern hold, or will it be altered?
   The answer requires determining whether the factors driving today’s market are
   fundamentally unchanged, have evolved incrementally or have been radically changed.
2. Has the market already taken the anticipated future events into account?
   If the factors driving the industry are the traditional cyclical ones, the market has likely
   taken them into account, because they are expected. If the factors represent a new element
   in the equation, then the market may not have expected them and may not have adjusted
   accordingly.

Question 33

How do the stock market’s various sectors or industries relate to the business cycle?

Answer 33

CONSUMER NON-CYCLICALS (CONSUMER STAPLES)

Stocks in consumer non-cyclicals (food) and consumer staples industries (cosmetics, tobacco,
beverages) tend to experience fairly steady demand and are less sensitive to changes in the
business cycle. These stocks typically attract investors when the economic cycle or bull market has
matured, or is in the early stages of contraction (see Figure 9.8).

CONSUMER CYCLICALS (DURABLES AND NON-DURABLES)

Stocks in this category include durables and non-durables, which are sensitive to interest rates as
well as the business cycle. Companies in this sector often lead the stock market at the bottom and
move up along with the market at the start of a new bull cycle (see Figure 9.9). Investors typically
buy consumer cyclicals when the economy is in late stages of contraction or early expansion.

HEALTH CARE

In general, stocks in this sector move similarly to consumer non-cyclicals. This sector is
considered defensive, meaning that companies are generally unaffected by economic fluctuations.
The health care industry consists of pharmaceutical firms, HMOs, biotechnology and medical
equipment suppliers. Pharmaceutical companies are affected by competitive market shares,
the pace of FDA approvals, patent lives and the strength of their R&D pipelines. Many
biotechnology firms are still in the development stage, with their valuations largely determined
by what investors believe their R&D pipelines are, or will be, worth. With new financing likely
to be more difficult to obtain in the future, strategic alliances between major drug companies and
biotech firms are expected to increase.

FINANCIALS

Stocks in housing-related industries tend to respond well to falling interest rates and are often
targeted by investors in the mid to late stages of an economic contraction. Non-mortgage-
dependent banks are generally driven by commercial and consumer loan growth, and tend to
be favoured by investors during the middle of the cycle. Financials are usually the first group to advance after a bear market and are considered a leading indicator of the equity markets
(see Figure 9.10).

TECHNOLOGY

Technology stocks can be cyclical based on their dependence on capital spending and business
or consumer demand. However, they may also have long-term growth potential as technological
products find broader applications, and as new technologies are developed. Technology stocks are
usually popular during early to mid stages of an economic expansion.

BASIC INDUSTRY (BASIC MATERIALS)

Profits of basic industries (chemicals, paper and forest, steel, etc.) are driven by high utilization
of capacity and strong market demand for products. Therefore, their stocks tend to be popular
with investors late in an economic expansion. For basic material companies, the global economic
picture and supply/demand factors also affect stock price movements.

CAPITAL GOODS

Capital spending tends to increase midway through the business cycle, as the economy is heating
up and higher demand for products leads companies to expand their production capacity.
Demand in global export markets is key for agricultural equipment, industrial machinery and
machine tools. Railroads and truckers tend to react early to a pickup in the economy. Airlines are
subject to cyclical fuel costs, usage versus capacity and competitive pressures on airfares.

ENERGY

This category includes large integrated international companies, domestic exploration companies
and energy services companies. Each industry has its own dynamics, but ultimately all are driven
by the supply and demand picture for energy worldwide. Political events have historically had a
major impact on these industries. Stocks tend to be popular with investors late in the business
cycle.

UTILITIES

Electric companies have historically been very sensitive to interest rates because of the large
debt financing costs they must incur in order to build their infrastructures. These stocks tend
to perform well in an environment of declining interest rates. Telephone companies may offer
attractive long-term growth opportunities, as they diversify and compete in recently deregulated
telecommunications markets.

PRECIOUS METALS

Precious metals and the stocks of companies that mine and process them can be affected by
industrial and consumer demand, but the largest factor contributing to volatility in this category
is generally inflationary pressure. Investors often flock to this category late in the expansion cycle.

Question 34

Describe the 8-step process to building an intermarket-based portfolio.

Answer 34

1. Identify the direction of global markets and related indexes.
2. Examine the four-year business cycle. What stage is the market in: expansion or contraction?
3. Asset allocation. Should the portfolio be weighted toward bonds or commodities? Apply
   long-term relative strength review of bonds and commodities (CRB).
4. Sector rotation. This confirms Step 2. What sectors have the highest relative strength? What
   sectors are declining or advancing now?
5. Identify the strongest sectors through relative strength analysis.
6. Identify the strongest performing ETFs or companies from the best performing sectors.
7. Establish targets and stops.
8. Repeat steps 1-7 weekly or monthly, depending on investment time frame, to maintain the
   best performing ETFs or stocks within a portfolio.

Question 35

Describe the several standard methods of diversifying a portfolio.

Answer 35

• by type of security (bonds, preferreds and common stock)—for an ETF-driven portfolio,
  currencies, bonds, commodities, indexes and sectors can all be used;
• by type of industry (i.e., paper-based or tangible-based);
• by type of industry classified by the business cycle;
• by degree of risk (high P/E, low P/E, high dividend, low dividend); and
• by geography of operation (i.e., Asia, Latin American, North America, etc.).