In an effort to see how various parts move together, it helps to take a broad and all-encompassing look at portfolio management. For instance, when the value of the dollar rises, the prices of commodities tend to decrease. This is due to the fact that most commodities are measured in dollars, so they suddenly appear to be better bargains.
Furthermore, higher prices associated with oil and agricultural products typically add to inflation. In turn, the bond market also responds with increasingly higher interest rates. Stocks are preferential when paired with lower interest rates, thereby allowing firms to expand as well as borrow, at which point equities tend to pull back.
The connections that exist among the four key asset classes (stocks, bonds, commodities, and currencies) follow a traditional pattern in an otherwise seemingly normal environment:
- Higher-value commodities indicate economic growth.
- Lower dollar value leads to higher commodity and gold prices.
- Low-value commodities are beneficial to stocks.
- Both stocks and bonds rise and fall together.
However, there are times where these connections will collapse, at which point you can gather additional insight into the circumstances.
Trends and turning points
Intermarket relationships are one of many factors that people consider when they are looking at their investing approach holistically. These relationships can also provide support in situations in which novel trading ideas or hints regarding market pivots are present, as well as when a new trend might be unfolding. That said, it is important to confirm suspicions or insight with concrete evidence.
For example, you should not combine all your commodities into one. Instead, take the time to draw comparisons between risk-friendly copper or lumber and risk-averse precious metals before you make your decision.
Also, remember that intermarket currents are not strictly limited to your investments. Business managers make forecasts and gauge the business cycle and its progression across a number of relevant sectors. Every group involved must also make it a point to incorporate nuances within their comparisons.
As another example, banks appreciate higher interest rates because charging more on interest benefits them in terms of their lending margins. On the other hand, the real estate industry prefers lower interest rates, which ultimately benefit mortgage borrowers. As a trend, when banks start to fare better than real estate agencies, the implication is that interest rates might soon be on the rise.
Additionally, consider the fact that during the majority of 2022, risk-friendly sectors, such as energy and financial, performed much better than did defensive or risk-averse sectors, such as utilities and consumer staples. From there, is it wise to interpret this comparison as a serious signal or sign that investors were adding risk to the mix?
Generally speaking, it is typically smarter to turn to a secondary signal and analyze the input said signal can provide. With this example in mind, while the riskier sector of credit outperformed the safer sector of bonds, you can proceed with confirmation that the original signal is supported by the additional signal.
Keep in mind that these relationship patterns tend to hold true over long periods of time. However, extreme events, aptly referred to as black swans given how rare they are, may sometimes cause relationships to react differently from what is expected. These relationships, or correlations, might not remain in stable condition as a result, seeing as how economic conditions constantly change on a global scale.
The inflation dilemma
Since the dawn of the COVID-19 pandemic, there has been an increase in inflation, which has also been a prominent theme in the world of investing. Will inflation end up being temporary in the way that policymakers originally promised the people?
To answer this question, it is first and foremost imperative to remember that an environment in which inflation is involved would indicate the strength behind the inflationary forces and the fact that they are stronger than the deflationary factors. However, this set of circumstances might not necessarily mean that runaway inflation is on the horizon, seeing as how that is quite the exceptional development.
Both inflation and deflation tend to fall in line with repetitive cycles. For instance, an inflationary environment existed from the 1970s through the 1990s.
Author John Murphy put out his classic book “Trading with Intermarket Analysis” in which he stated that the entire world dipped into a deflationary climate after 1998, at which point Asian central banks increased their interest rates as a way of defending their currencies. This caused a lot of damage, as the banks’ decision ended up stifling economies, lifting bonds and cratering stocks. In turn, interest rates entered into the beginning of a very long-winded decline.
With deflation, stocks and bonds move in opposite directions. Various other asset classes experience changes as well.
- Inverse movement:
- Commodities and bonds.
- Commodities and dollars.
- Parallel movement:
- Stocks and commodities.
Bonds tend to experience a decline as investors choose to turn their attention toward hard assets and gold with the intention of protecting their purchasing power to the best of their abilities. In fact, in the early stages of increasing interest rates, stocks can continue to increase as long as the economy’s growth keeps rising.
Year of the swan
COVID-19 introduced a new low in March 2020, at which point stocks began rising and bonds were doing anything but that. Two years later, a number of unexpected relationships emerged.
For instance, the relationship between the dollar and commodities started to diverge, but there was a period of time in 2022 in which the relationship changed in such a way that both factors started moving in the same direction and rising together. Commodities later returned to their original state following the Ukraine spike.
In time, the markets might suggest that we are starting to surpass black swan threats, including the pandemic and the Ukraine invasion. Intermarket analyses can provide your portfolio with an edge unlike any other. To learn more about asset relationships, speak to your financial adviser today.