Chapter 9 - Intermarket Analysis (Done) Flashcards

Question

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

Answer 1

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.

Answer 2

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.

Answer 3

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

Answer 4

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.

Answer 5

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.

Answer 6

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

Answer 7

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.

Answer 8

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.

Answer 9

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.

Answer 10

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.

Answer 11

* 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.).