4.
Market Focal Points Your Edge For An Accurate
Intermarket Analysis.
© By: Ned Gandevani, Ph.D.
Copyright 2000
Intermarket analysis typically reveals the relationship between two different
markets. In the hands of the technical trader it is primarily used as a tool to
evaluate supportive and confirming information of the performed analysis. It can
be a valuable tool for the position trader whose primary outlook is the major
daily trend of a market. For the day trader however, intermarket analysis can be
nothing less than a disaster. In this article, we will review the fundamental
premises of intermarket analysis and market relationships and illustrate why
this type of thought process can be detrimental to the day trader. In doing so,
we will look to Internal Dynamics as the primary factor in market movement. A
systematic approach to market behavior supports this important assumption.
External factors may perturb the market’s dynamic equilibrium and cause
deviations from its habitual patterns for a short time, but after awhile the
market will resume its natural order and rhythm. External factors that are
strong enough to influence market movement and direction can be referred to as
Focal Points.
Focal Points helps both day traders and swing traders to take full
advantage of intermarket analysis and avoid any associated its pitfalls. By
understanding and implementing intermarket analysis under the guidance and
influence of Focal Points, one could develop a meaningful insight on the
different markets’ movements and their influence on each other.
1. What is an Intermarket Relationship?
Markets, like
elements in real life constantly interact with one another, so that movement in
one will most likely cause a movement or reaction in another. Intermarket
analysis takes this fact into consideration and acknowledges that markets do not
behave in isolation. In a systematic approach to the study of financial markets,
the elements of economy and crowd psychology influence market behavior. Along
with this, each market acting as a member of a larger group will interact with
other members as well, and therefore create intermarket relationships. The basic
concept of "systems theory" is that everything is part of a system and each
system is then part of another greater system. Analysis of any single part of a
system without giving recognition to the other parts of the system as a whole
(to include their structures and functions) will fall short of a fuller
understanding. The "general systems theory" enables technical analysts to better
appreciate the complexity and inter-related nature of their studied markets. A
good example of an intermarket relationship would be when the equity market
reacts to a sell-off in the Bond market, which would in turn effect, the
commodity and U.S. Dollar markets.
Bar Rosenburg,
in the Journal of Portfolio Management writes:
"Studies in equity and bond markets confirm that broad-based indexes of returns
within each market are highly correlated, even though the included securities
and index weights are different. The correlation is high because any widely
based and correctly computed index tends to show up the prominent factor and
becomes a surrogate for it. " (Streetwise, the Best of the Journal of Portfolio
Management, p.15,
1998, Princeton University Press)
According to
John Murphy: "Intermarket technical analysis refers to the application of
technical analysis to these intermarket linkages." Furthermore, he asserts that:
"[It] is no longer possible to study any financial market in isolation, whether
it’s the U.S. stock market or gold futures. Stock traders have to watch the bond
market. Bond traders have to watch the commodity markets. And everyone has to
watch the U.S. dollar." (John Murphy 1991, Intermarket Technical Analysis, pp.
1-2)
The following
charts clearly illustrate the intermarket relationships
of various selected markets.
Figure 1
In the above
Figure 1 daily chart of the S&P, Dollar Index, and the CRB Index he correlation
in price is often times in sync with one another and then the relationship will
invert or de-couple for a period of time only to return to a parallel
relationship again. On a daily basis and for position trading the correlation
could prove to be useful.
Figure 2
The Figure 2
(above) daily chart clearly shows at this point in time that the S&P, Bonds, and
Crude oil are moving in "sync" as all eyes are on interest rates and worries of
inflation loom in the distance.
Intermarket analysis also plays an important role in portfolio theory. To
diversify and maximize ones portfolio return, it is imperative to know the
correlation between selected markets. For example, a more diversified portfolios
created when the markets have correlation coefficients close to zero. This would
assure that the movement of one market would be unrelated to the movements of
the other markets.
2. Intermarket Analysis Does Not Generate Signals
A study of
intermarket relationships and analysis provides important background
information. For the longer term investor or position trader, intermarket
analysis might give help reveal major turn-around periods that are the result of
diverging markets. To give too much value to this particular form of technical
analysis can also be a poor choice. Investors or traders can be misled into
believing that markets can be traded solely on this type of technique. John
Murphy states that "The key word here is ‘background’. Intermarket work provides
background information, not Primary information. Traditional technical analysis
still has to be applied to the markets on an individual basis, with primary
emphasis placed on the market being traded. Once that’s done, however, the next
step is to take intermarket relationships into consideration to see the
individual conclusions make sense from an intermarket
perspective."
Consider the
Bond and S&P futures markets. These two markets usually trend in the same
direction, as the equity market enjoys a high level of growth, under a low
interest rate environment. Let’s say for example, that a position trader has
analyzed both markets and has concluded that the S&P’s are in an uptrend, but
the Bond futures have a bearish outlook. According to his theory of intermarket
analysis, there is usually a direct relationship between the two. These two
contradicting conclusions will then serve as a warning to our trader to review
his "homework" one more time, or at the very least to approach either trade with
extreme caution. This example is a good illustration of how intermarket analysis
can be a useful tool to compliment one’s technical analysis of a market or
security.
With the
recent advancements in technology and the affordability of high-tech trading
related software, there has been a huge surge in the availability of mechanical
trading systems that utilize intermarket relationships as their primary tool for
signal generation. When the Bond and S&P markets de-coupled their typical
relationship, we could observe extensive losses on those systems primarily based
upon their step-lock movements. This further illustrates that intermarket
analysis does not replace the hard work of detailed technical analysis for a
given market - it will merely aid in proving additional, important information.
3. Does Intermarket Analysis Apply to Day Trading?
Intermarket
analysis might look seductive to the day trader as a way to help simplify his or
her trading decisions - but the process can be a deadly sin as well. Since day
traders need to digest so much information during the trading session for proper
trade entry and exit decisions, the use of intermarket analysis can lead to a
"simplicity trap" for the unsuspecting. For example, an S&P day trader might
look into the movement of the Cash market to provide a leading indicator for the
futures. Bond traders tend to watch the S&P for their lead during the day. As a
matter of fact, most of my prospective students have stated that the Cash and
Bond markets were primary factors in their S&P trading plans.
In an
intraday market, such as the S&P’s, the relationship between two markets is
within the "noise" level generated - and it’s anyone’s guess as to who will lead
who. It’s like the old adage of "which came first - the chicken or the egg".
Each individual market moves according to its own internal dynamics. For
example, the S&P 500 as a financial market, shares a set of common
characteristics with other financial markets. Because of this commonality, it
will react to economic news and related financial numbers upon public release.
As an illustration, changes in the interest rate will have a significant impact
on Bond, S&P, currency and other related financial markets. Even though other
markets such as the physical commodities might also have a reaction to economic
change, their impact would be to a much lesser extent and lower significance,
relative to the core financial markets. The CRB Index may very well respond to a
specific event but the S&P would react in a fashion more similar to the Bonds
and Dollar.
Let’s consider a neighborhood as an example. It would be typical that
houses built in a demographic area would have a definite variety of home styles
as well as market values. Members of that demographic area would typically have
a fairly equal level of income, family size, as well as other common features.
In the case of an occurrence such as an earthquake, tornado or water/electricity
outage, it’s conceivable that all the households would react to these external
factors in almost the same manner. If one household goes on vacation it does not
mean that the neighboring house would go on vacation as well. Additionally, if
the head of one household is employed as a financial analyst or physician it
does not mean that the person next door has the same occupation. A wedding or
birthday party in one house does not mean that all houses in that demographic
area are engaging in the same. Each household acts and behaves according to it’s
own Internal Dynamics. The convergence of behavior among the different
households would probably only occur in the presence of an external factor, such
as the ones listed previously.
These same principals apply to each member that makes up the Financial
Markets Group. Although they may react to the same intensity of economic
exogenous factors and international shock-news, each will react accordingly
based upon its own Internal Dynamics. Therefore, it would be baseless and
erroneous for the day trader to follow one market yet trade another. A day
trader must study and analyze the Internal Dynamics of his chosen market before
attempting to trade it.
Figure 3
Many day-traders watch the Dow as confirming indicator of price movement in
the S&P. Yet a quick glance at the daily chart in Figure 3 shows once again the
correlation is one that cannot be relied upon in the short term. From the end of
March to the first week in April the Dow was making new highs while the S&P was
not following. Conversely at the end of February the Dow was making new lows and
the S&P was not. From mid April to the first week in June the S&P and the Dow
paralleled each other fairly accurately only to lose sync for the last two weeks
in June and again resume their lock step relationship in July.
Figure 4
Figure 4
shows a 5-minute chart for both the S&P and the Dow. Although many of the moves
are in sync….often times new lows in the Dow will not be accompanied by new lows
in the S&P and new highs in the S&P will now be accompanied by the Dow. Clearly
for in intra-day trader relying on other markets for signals and confirmation
can be a costly mistake.
Figure 5
Looking at
the 5m S&P and Bond charts , Figure 5, will show you
that any system trading the S&P relying on the "lock-step" correlation
in the S&P and the Bonds will not be very reliable for any given length of time.
Figure 6
Again…..the
Figure 6 above for the S&P and the Bonds clearly
demonstrate a total de-coupling of relationship for any trading
purposes only to re-emerge at a later date in total sync with one another.
The S&P 500
as a member of the Financial Market Group, exhibits a set of characteristics
common to its fellow group members. When a day trader attempts to simplify his
trading criteria, there is a great appeal to look for a special indicator - or
market - to act as a leading indicator. The hard truth is that each market makes
moves based upon its own set of Internal Dynamics. Some of the significant
elements of Internal Dynamics include the Market Map, Market Participant
Composition, Liquidity, Average Daily/Intraday Movement and Dynamic Boundaries
of the Market. . In future articles I’ll discuss the above listed elements in
greater detail.
Intermarket
Analysis can be a great additional tool for technical analysts, but it’s only
a tool and it’s not a substitute for diligent study of a particular market. For
a day trader, the use of intermarket analysis for trade initiation and
management is a deadly sin, since the primary factors of market movement are a
result of the Internal Dynamics. Day traders
need to develop greater insight into the Internal Dynamics which affect and
shape their chosen market, as well as learn when to stand aside when in the
presence of external factors (shock news and exogenous economic news) that are
grossly out of the ordinary. Focal Points
represent the fundamental changes and economic news events that a market will
focus on at any given period. In their search to identify the primary cause of
price movement, market participants gather their focus on specific economic news
(foreign or domestic). For example, the Focal Point of today might be the
Japanese Yen, tomorrow the European bank interest rates, the PPI the following
day, and so on. The Focal Point of today might not have any importance for
tomorrow. It has been observed that depending on the market mood, participants
will interpret different news in different ways. This phenomenon is a direct
result of the dynamics of Focal Points. Focal Points also play a more
significant role in the presence of increased uncertainty and a lack of clear
direction. Under these conditions, any small or benign factor could be
considered a Focal Point.
One major
characteristic of Focal Points is that they are dynamic
and don’t remain or project the same intensity with the passage of time. Focal
Points that create relationships between two different markets cannot be
expected to last, which is why intermarket analysis as well as simple linear
techniques cannot be used as a static indicator. Most of the time intermarket
relationships will fail to act as forecasted or expected because of the change
of a Focal Point.
Being aware
of the temporary influence of Focal Points allows us to execute better entries
and exits with our trades. Remember that Focal Points are the principal causes
of optimism and pessimism in the market, causing the participants to swing from
one emotional extreme to the other. Present and current information carries more
weight in the minds of the participants than older, previous events.
As traders,
we have to be aware of the fact that the market can be under the influence of
external factors like report releases/leaks, war, shortage, etc. The impact and
influence of these can intensify the internal dynamics of the market and cause
quicker than normal reactions at turning points. The savvy trader will therefore
be aware of both internal dynamics as well as external factors when considering
a trade.
Figure 7
In the above
example on 8/22, Figure 7, the Focal Point was on interest rates as the FOMC
announcement of the Fed’s decision of whether or not to raise rates was going to
be released. As the charts show there was a correlation of movement between the
S&P and T-Notes.
Figure 8
However,
after the announcement on the 22nd, the following days show an
inverse relationship again with the T-Notes and the S&P as the Focal Point has
shifted away from interest rates, see Figure 8.
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