Intermarket Analysis – How Markets Affect Each Other

By Darrell Jobman ISSUE 802 | February 2009

As you already know, 2008 was a rather extraordinary year for many markets, featuring price moves that are unprecedented in our lifetime. In some cases, the changes since the end of 2007 have been shocking, especially to anyone with a 401(k), IRA or some other type of plan holding stocks and mutual funds, as the stock market registered its biggest setback since 1931 during the Great Depression years. Just think of the major banks, brokerage firms, hedge funds and companies that existed a year ago that no longer exist today.

At the beginning of 2008, we didn’t know we were entering what would be proclaimed months later as an official economic recession. We might have suspected as much after some of the first bumps of the sub-prime mortgage debacle began to unfold in the summer of 2007, but at the end of the year stocks were still at rather lofty levels. Prices of commodities such as crude oil, soybeans, gold and others were climbing to new heights as well.

The market environment going into 2008 was quite different than what it was at the end of the year. So what was different about 2008 to make markets respond as they did, and what effect did the so-called outside markets have on prices?

House of Cards Tumbling Down - I

Some day historians and economists are going to write a lot about the crash of 2008 and the likely carryover effect in 2009. But here is a non-economist, layman’s review of some of the steps that led to the influence of outside markets that we are talking about in this article:

• Housing market begins to crumble.
• Sub-prime mortgage, ARMs ‘packages’ begin to smell.
• Confidence in the value of these debt-related derivative instruments begins to waiver.
• Confidence in firms dealing in these instruments shaken, starting a credit crisis.

As you are well aware, investors seem to be prone to bubbles – market moves that get carried away with themselves and then burst. We see the cycle again and again from the legendary South Sea tulip mania to today’s situation, just like fads from hula-hoops to Cabbage-Patch dolls to pet rocks.

Somehow, over the years, everyone became ingrained with the idea that a home is an investment, not an expense, and that property prices would always go up. Now combine several things – the social climb to newer and bigger and ever more expensive homes including the “McMansions” that popped up in many housing developments, government incentives to get more people to buy their own homes, a stock market that didn’t look nearly so attractive after the dot.com bubble burst in early 2000 – and you had the start of a housing bubble in 2002 or 2003. It wasn’t just real estate that got bid up, but commodity prices in general also started to rise. They became the places for investors to be.

As the loans for housing got bigger and the requirements for buying diminished, some people figured out clever ways to bundle mortgages and debt into new derivative instruments that they could market and pass along to banks and hedge funds and others, and somehow these instruments got top ratings from rating services. They operated with the belief and assurance that these instruments were protected by insurance provided by companies like AIG.

Greed surpassed risk-management concerns. It was the hottest new way to get rich, and many financial firms just had to participate to earn the big profits that their competitors were getting.

But then the sub-prime mortgages (those loans to those least likely to be able to repay them) and the short-term adjustable rate mortgages (the ARMs) began to come due. Many buyers, unable to meet new loan terms, backed away from them and the defaults and foreclosures began to mount up. Before long, the value of derivative instruments containing these loans became suspect as investors began to question what they were really worth. Then people lost confidence in the value of these instruments and in the firms dealing in them.

One of the big problems is that no one knew which instruments had value and which did not, and no one really knew the value of what the firms did hold. So firms were not willing to deal with other firms because they couldn’t tell what they might be getting. Without pricing, the market had no way of assessing value, and it was clear that the number of non-performing loans and worthless debt instruments was growing.

House of Cards Tumbling Down – II

By this time, you are probably wondering how this brief and inadequate review of history relates to outside markets. We’re trying to set that up.

As property and other investments began to fizzle or, in the case of stocks, remain rather stagnant for a time, hedge fund managers began to look for other investment opportunities. The U.S. dollar’s decline from 2002 into 2008 helped to boost commodity prices and nearly everyone assumed that growing demand from China and India would cause a long-term commodity boom. Hedge funds and other fund managers jumped into commodities as another asset class in a big way. The result was record prices for crude oil and other commodities.

Then, as the credit and financial crisis grew into a threat to the global financial system, many firms and hedge funds were forced to dump every investment they could just to raise cash in an effort to keep the firm in business.

Last fall, Cash became king, and no matter how sound an investment in oil, grains or gold might have been, investments in commodities became expendable. As the big-money traders trimmed commodity holdings, selling exacerbated price declines to lower levels than probably deserved in some cases.

How much of these moves are due to changes in value?

How much of this run-up in crude oil futures prices to $147 a barrel last July was due to the real rise in value of a barrel of oil? How much of the collapse in prices from above $147 to below $35 a barrel in late 2008 was due to the actual decline in the value of oil? Yes, the supply-demand picture was altered somewhat as oil producers like OPEC cut output and global economic conditions weakened, reducing demand for oil. But the changes in fundamentals don’t seem to be substantial enough to cause such a drastic swing in prices.

You can probably apply some of the same observations from crude oil futures to soybean futures, which ran up to $16.50 a bushel, then dropped in half, rallied back into the double digits and have since dropped back again. Most commodities followed a similar pattern.

One commodity that hasn’t followed the pattern quite so precisely is gold, which broke through price barriers going back to 1980, peaked in March ahead of the rest of the commodity world, and hasn’t experienced the severe sell-off that many commodities have had. On the other hand, gold prices also have not kept pace with the projections of bulls that see an economic future ahead that is likely to be volatile and very inflationary.

The Most Prominent “Outside Market” – The U.S. Dollar

So what are the outside markets that really matter? Markets are complex, and there are no sure connections that always apply. But when we talk about outside markets and intermarket analysis, we can make some general conclusions, starting with the value of the U.S. dollar. No matter what you are trading, you almost need to be a currency analyst because the value of the dollar is such an important factor in commodity pricing.

In general, when the dollar is strong and rising, prices of oil and most other commodities priced in dollars will be weaker. When the dollar is weak and declining, prices for commodities priced in dollars move up.

In the current economic situation, everyone wants to hoard cash, raising demand for dollars and, therefore, the value of the dollar relative to other currencies. And with prices of many markets sinking, dollar holders do not have much incentive to convert their dollars into commodities or stocks or anything other than cash. So as long as the value of the dollar is firming, it makes good economic sense to hang on to dollars, adding to the deflationary undercurrent that seems to be in control of global economies today.

Dollar strength may not last forever, based on the belief by many that government bailouts and other unprecedented spending will flood the market with so many Treasury instruments and dollars that there will be no other recourse than a weaker U.S. currency. But the market is not there yet, and may not be until 2009.

As commodity prices were going up, the U.S. Dollar Index (a futures market based on the dollar’s standing versus six currencies) was going down. When the value of the dollar began to climb, mostly because economic conditions in other major nations were worse than U.S. conditions, commodity prices fell. The inverse relationship of the U.S. Dollar Index and Continuous Commodity Index is reflected by a minus 94 percent correlation between these two indexes in 2007 and 2008, about as opposite as you can get.

There are many factors that affect the value of a currency. In my opinion, no market is more difficult to analyze than currencies. Major currencies, most notably the euro, which just marked the 10th anniversary of its launch on January 1, 1999, tend to have a chart pattern that is a mirror image of this U.S. dollar chart, but that is not always the case.

Sometimes the commodity currencies – the Canadian and Australian dollars – track each other closely. The euro, British pound and Swiss franc also tend to track and influence each other. But those relationships are hardly carved in stone, especially when there is some major news event like an interest rate change in one country.

One of the key areas to watch is the interest rate differential among nations as large traders conduct carry trades to take advantage of rate differences by borrowing in the currency with the lower rate and investing the money where rates are higher. Previously, that meant borrowing in Japanese yen with interest rates at only 0.3 percent, creating more demand for yen, and investing in U.S. dollars at a higher rate. That spurred the yen to record levels against the dollar. But now U.S. short-term rates are almost down to zero, and most other nations are also in a rate-cutting mode so there is not much more that countries can do with interest rates.

For a nation like Japan with its reliance on exports, a strong yen can be a problem for companies like Sony, which blamed the yen as one factor in projecting a loss of more than $1 billion this year.

Japan has a strong motivation to weaken the yen to encourage foreign sales. Interest rates can’t go any lower so one alternative could be currency intervention, which has repercussions for the value of the dollar and, by extension, the prices of all commodities priced in dollars. Other nations also have similar interests in supporting their exports, to a greater or lesser degree.

Bottom line: If you are a trader, you need to watch what is happening in currency markets.

Other Outside Markets

Crude oil is probably the leading commodity affected by the value of the U.S. dollar. It probably has the most influence on other markets as an outside market. As crude oil prices go, so go prices for many other commodities because energy is an essential ingredient in producing, shipping and distributing so many other commodities and products that are vital to the economy.

The tone of oil pricing often sets the tone for other markets. A bullish price move for oil may be enough to overcome bearish fundamentals and lower prices for other markets on a given day. That’s not always the case but there are many times when oil, grains and other commodities trade in concert because of the dominant influence of oil or gold versus the U.S. dollar. Correlation studies show that corn and crude oil had a positive 85 percent correlation during the last two years, which might be expected with the U.S. mandate for using ethanol made from corn in fuel. Wheat and crude oil had a positive 70 percent correlation; cotton and crude oil had a 81 percent correlation.  

Of course, the fundamentals of keeping price relationships among commodities in line is always a factor in intermarket analysis as one commodity influences another market.  Sometimes related markets will go their own way but, in general, a strong day in soybeans (for example) would support a similar movement in corn or wheat, even if the fundamentals for the grains might suggest a bearish move.

Psychological Outside Markets

The charts for financial markets look somewhat different than the commodity charts, as you might expect. The E-mini S&P 500 Index and crude oil futures had a correlation of only 15 percent during the last two years. However, the correlation of the Nasdaq Index and crude oil was a positive 42 percent. Ten-year Treasury note futures are in line with the E-mini S&P, with a correlation to crude oil futures of 18 percent.

Psychologically, however, these financial markets can have a bearing on commodity prices on a given day, especially on those days when stocks fall sharply and overall market attitude turns sour. As mentioned earlier, social mood and traders’ moods can put a damper on the whole market complex.

Summary - What Drives Outside Markets?

So what is behind the big moves we see in the most prominent outside markets? Here is a breakdown of the key factors:

• Fundamentals of an individual commodity and related commodities
• Intermarket relationships
• Currency fluctuations, notably the U.S. dollar
• Makeup of market participants

If a given market is influenced by outside markets, then these items that influence movements in outside markets are areas that the astute trader should be monitoring.

Darrell Jobman is Editor-in-Chief of TraderPlanet.com, a Web site that provides free information and education for traders.  It includes daily and weekly market commentaries, tutorials and a number of other resources for traders. Darrell Jobman can be reached by email at Darrell@traderplanet.com.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached at editor@lind-waldock.com.

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