And the leading action the dow jones utility average

INTERMARKET
TECHNICAL
ANALYSIS

John J. Murphy

Copyright ©1991 by John J. Murphy
Published by John Wiley & Sons, Inc.

Like that of most technical analysts, my analytical work for many years relied on
traditional chart analysis supported by a host of internal technical indicators. About
five years ago, however, my technical work took a different direction. As consulting
editor for the Commodity Research Bureau (CRB), I spent a considerable amount of
time analyzing the Commodity Research Bureau Futures Price Index, which measures
the trend of commodity prices. I had always used the CRB Index in my analysis of
commodity markets in much the same way that equity analysts used the Dow Jones
Industrial Average in their analysis of common stocks. However, I began to notice
some interesting correlations with markets outside the commodity field, most notably
the bond market, that piqued my interest.

vi PREFACE

for the stock market crash in the fall of that year. The interplay between the dollar, the commodity markets, bonds, and stocks during 1987 convinced me that intermarket analysis represented a critically important dimension to technical work that could no longer be ignored.

John J. Murphy
February 1991

1

Think back to 1987 when the stock market took its terrible plunge. Remember how all the other world equity markets plunged as well. Remember how those same world markets, led by the Japanese stock market, then led the United States out of those 1987 doldrums to record highs in 1989 (see Figure 1.1).

Turn on your favorite business show any morning and you'll get a recap of the overnight developments that took place overseas in the U.S. dollar, gold and oil, treasury bond prices, and the foreign stock markets. The world continued trading while we slept and, in many cases, already determined how our markets were going to open that morning.

JAPAN, AND BRITAIN. GLOBAL MARKETS COLLAPSED TOGETHER IN 1987. THE SUBSEQUENT

GLOBAL STOCK MARKET RECOVERY THAT LASTED THROUGH THE END OF 1989 WAS LED BY

ALL MARKETS ARE RELATED

What this means for us as traders and investors is 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. Then there's the Japanese stock market to consider. So who needs intermarket analysis? I guess just about everyone; since all sectors are influenced in some way, it stands to reason that anyone interested in any of the financial markets should benefit in some way from knowledge of how intermarket relationships work.

related markets in much the same way that traditional technical indicators have been employed. Stock technicians talk about the divergence between bonds and stocks in much the same way that they used to talk about divergence between stocks and the advance/decline line.

Markets provide us with an enormous amount of information. Bonds tell us which way interest rates are heading, a trend that influences stock prices. Commodity prices tell us which way inflation is headed, which influences bond prices and interest rates. The U.S. dollar largely determines the inflationary environment and influences which way commodities trend. Overseas equity markets often provide valuable clues to the type of environment the U.S. market is a part of. The job of the technical trader is to sniff out clues wherever they may lie. If they lie in another market, so be it. As long as price movements can be studied on price charts, and as long as it can be demonstrated that they have an impact on one another, why not take whatever useful information the markets are offering us? Technical analysis is the study of market action. No one ever said that we had to limit that study to only the market or markets we're trading.

Although economic forces, which are impossible to avoid, are at work here, the discussions of those economic forces will be kept to a minimum. It's not possible to do intermarket work without gaining a better understanding of the fundamental forces behind those moves. However, our intention will be to stick to market action and keep economic analysis to a minimum. We will devote one chapter to a brief discussion

The key to intermarket work lies in dividing the financial markets into these four sectors. How these four sectors interact with each other will be shown by various vi-sual means. The U.S. dollar, for example, usually trades in the opposite direction of the commodity markets, in particular the gold market. While individual commodities such as gold and oil are discussed, special emphasis will be placed on the Commod-ity Research Bureau (CRB) Index, which is a basket of 21 commodities and the most

FIGURE 1.2

MARKET.

Dollar Index Stocks

BASIC PREMISES OF INTERMARKET WORK

Before we begin to study the individual relationships, I'd like to lay down some basic premises or guidelines that I'll be using throughout the book. This should provide a useful framework and, at the same time, help point out the direction we'll be going. Then I'll briefly outline the specific relationships we'll be focusing on. There are an infinite number of relationships that exist between markets, but our discussions will be limited to those that I have found most useful and that I believe carry the most significance. After completion of the overview contained in this chapter, we'll proceed in Chapter 2 to the events of 1987 and begin to approach the material in more specific fashion. These, then, are our basic guidelines:

6. Futures-oriented technical indicators are employed.

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 if the individual conclusions make sense from an intermarket perspective.

Suppose intermarket work suggests that two markets usually trend in opposite directions, such as Treasury bonds and the Commodity Research Bureau Index. Suppose further that a separate analysis of the top markets provides a bullish outlook for both at the same time. Since those two conclusions, arrived at by separate analysis, contradict their usual inverse relationship, the analyst might want to go back and reexamine the individual conclusions.

Intermarket analysis has a totally different focus. It suggests that important directional clues can be found in related markets. Intermarket work has a more outward focus and represents a different emphasis and direction in technical work.

One of the great advantages of technical analysis is that it is very transferable. A technician doesn't have to be an expert in a given market to be able to analyze it technically. If a market is reasonably liquid, and can be plotted on a chart, a technical analyst can do a pretty adequate job of analyzing it. Since intermarket analysis requires the analyst to look at so many different markets, it should be obvious why the technical analyst is at such an advantage.

Prior to 1972 stock traders followed only stocks, bond traders only bonds, currency traders only currencies, and commodity traders only commodities. After 1986, however, traders could pick up a chart book to include graphs on virtually every market and sector. They could see right before their eyes the daily movements in the various futures markets, including agricultural commodities, copper, gold, oil, the CRB Index, the U.S. dollar, foreign currencies, bond, and stock index futures. Traders in brokerage firms and banks could now follow on their video screens the minute-by-minute quotes and chart action in the four major sectors: commodities, currencies, bonds, and stock index futures. It didn't take long for them to notice that these four sectors, which used to be looked at separately, actually fed off one another. A whole new way to look at the markets began to evolve.

On an international level, stock index futures were introduced on various overseas equities, in particular the British and Japanese stock markets. As various financial futures contracts began to proliferate around the globe, the world suddenly seemed to grow smaller. In no small way, then, our ability to monitor such a broad range of markets and our increased awareness of how they interact derive from the development of the various futures markets over the past 15 years.

For one thing, I'll be using mostly price-based indicators. Readers familiar with traditional technical analysis such as price pattern analysis, trendlines, support and resistance, moving averages, and oscillators should have no trouble at all.

Those readers who have studied my previous book, Technical Analysis of the Futures Markets (New York Institute of Finance/Prentice-Hall, 1986) are already well prepared. For those newer to technical analysis, the Glossary gives a brief introduction to some of the work we will be employing. However, I'd like to stress that while some technical work will be employed, it will be on a very basic level and is not the primary i focus. Most of the charts employed will be overlay, or comparison, charts that simply compare the price activity between two or three markets. You should be able to see these relationships even with little or no knowledge of tech-nical analysis.

The key to understanding the intermarket scenario lies in recognizing the often overlooked role that the commodity markets play. Those readers who are more involved with the financial markets, and who have not paid much attention to the commodity markets, need to learn more about that area. I'll spend some time, therefore, talking about relationships within the commodity markets themselves, and then place the commodity group as a whole into the intermarket structure. To perform the latter task, I'll be employing various commodity indexes, such as the CRB Index. However, an adequate understanding of the workings of the CRB Index involves monitoring the workings of certain key commodity sectors, such as the precious metals, energy, and grain markets.

KEY MARKET RELATIONSHIPS

4. The inverse relationship between commodities and bonds.

5. The positive relationship between bonds and the stock market.

This chapter introduces the concept of intermarket technical analysis and provides a general foundation for the more specific work to follow. In Chapter 2, the events leading up to the 1987 stock market crash are used as the vehicle for providing an intermarket overview of the relationships between the four market sectors. I'll show how the activity in the commodity and bond markets gave ample warning that the strength in the stock market going into the fall of that year was on very shaky ground. hi Chapter 3 the crucial link between the CRB Index and the bond market, which is the most important relationship in the intermarket picture, will be examined in more depth. The real breakthrough in intermarket work comes with the recognition of how commodity markets and bond prices are linked (see Figure 1.3).

Chapter 4 presents the positive relationship between bonds and stocks. More and more, stock market analysts are beginning to use bond price activity as an important indication of stock market strength. The link between commodities and the U.S. dollar will be treated in Chapter 5. Understanding how movements in the U.S. dollar affect the general commodity price level is helpful in understanding why a rising dollar is considered bearish for commodity markets and generally positive for bonds and stocks. In Chapter 6 the activity in the U.S. dollar will then be compared to interest rate futures.

BONDS AND COMMODITIES USUALLY TREND IN OPPOSITE DIRECTIONS. THAT INVERSE

RELATIONSHIP CAN BE SEEN DURING 1989 BETWEEN TREASURY BOND FUTURES AND THE

The Dow Jones Utility Average is recognized as a leading indicator of the stock market. The Utilities are very sensitive to interest rate direction and hence the action in the bond market. Chapter 10 is devoted to consideration of how the relationship between bonds and commodities influence the Utility Average and the impact of that average on the stock market as a whole. I'll show in Chapter 11 how relative strength, or ratio analysis, can be used as an additional method of comparison between markets and sectors.

Chapter 12 discusses how ratio analysis can be employed in the asset allocation process and also makes the case for treating commodity markets as an asset class in the asset allocation formula. The business cycle provides the economic backdrop that determines whether the economy is in a period of expansion or contraction. The financial markets appear to go through a predictable, chronological sequence of peaks and troughs depending on the stage of the business cycle. The business cycle provides some economic rationale as to why the financial and commodity markets interact the way they do at certain times. We'll look at the business cycle in Chapter 13.

FIGURE 2.1
THE INVERSE RELATIONSHIP BETWEEN BOND PRICES AND COMMODITIES CAN BE SEEN FROM
1985 THROUGH 1987. THE BOND MARKET COLLAPSE IN THE SPRING OF 1987 COINCIDED
WITH A BULLISH BREAKOUT IN COMMODITIES. THE BULLISH "HEAD AND SHOULDERS"

12

BOTTOM IN THE CRB INDEX WARNED THAT THE BULLISH "SYMMETRICAL TRIANGLE" IN BONDS WAS SUSPECT.

in 1986. One was the Chernobyl nuclear accident in Russia in April 1986 which caused strong reflex rallies in many commodity markets. The other factor was that crude oil prices, which had been in a freefall from $32.00 to $10.00, hit bottom the same month and began to rally.

Figure 2.1 shows that the bullish breakout by the CRB Index in April 1987 co-incided with the bearish breakdown in bond prices. It became clear at that point that two major props under the bull market in stocks (rising bond prices and falling commodity prices) had been removed. Let's look at what happened between bonds and stocks.

THE BOND COLLAPSE- A WARNING FOR STOCKS

DROP UNTIL THE SPRING OF 1987. THE COLLAPSE IN BOND PRICES IN APRIL OF 1987 (WHICH

COINCIDED WITH AN UPTURN IN COMMODITIES) WARNED THAT THE STOCK MARKET RALLY

Although the rally in the CRB Index and the collapse in the bond market didn't provide a specific timing signal as to when to take long profits in stocks, there's no question that they provided plenty of time for the stock trader to implement a more defensive strategy. By using intermarket analysis to provide a background that suggested this stock rally was not on solid footing, the technical trader could have monitored various stock market technical indicators with the intention of exiting long positions or taking some appropriate defensive action to protect long profits on the first sign of breakdowns or divergences in those technical indicators.

FIGURE 2.3

A COMPARISON OF BONDS, STOCKS, AND COMMODITIES FROM 1985 THROUGH 1987. THE

FIGURE 2.4

Interest Rates versus Stocks