Adam O’Dell | Friday, March 29, 2013 >>
Today is a good day to talk about… intermarket analysis.
Much like the topic of cycles, I’m forbidden to speak of such things in social circles. So I save these topics for you, good reader. You came to Survive & Prosper because, presumably, you aim is to do just that – survive these difficult economic times and prosper from the “new normal” markets… which can be more perplexing than ever.
I won’t sugarcoat this: financial markets are complex. There’s no way around it. And unfortunately for many, the complexity is what drives most average investors out of the markets, with nothing but a tucked tail and zero balance to show for their valiant attempts to crack the code.
But you are here, so I don’t expect that will ever be your fate.
Here’s a trick question for you:
For each of the following, list the one thing most important to the success of each type of athlete:
1) A baseball pitcher
2) A Tour de France cyclist
3) A football linebacker
Write your answers down…
Now, if you wrote throwing arm, leg strength and weight respectively, you’re wrong.
In fact, you could have listed any body part, or referred to any physical or mental strength and you’d still have been wrong.
The right answer is…
A good coach.
A pitcher’s success is not solely based on the strength of his arm. It’s not based on his eye-hand coordination alone… not just on his leg strength… or the size of his throwing hand.
A pitcher’s success is based on ALL of these factors, plus many I haven’t mentioned. However, without the expert guidance of a great coach, none of those pieces would take an athlete all the way to the top of his chosen sport.
You see, most athletes don’t have the ability to self-assess. But an outside observer, like a coach, can assess his trainees with the independence, rationality and completeness needed for success.
A pitcher can focus on his grip of the ball, but in doing so he might lose focus of where he points his plant foot when he strides forward. But a good coach sees it all. He recognizes, and works with, three crucial facts:
1) There are countless “moving parts” to a successful athlete…
2) You’re only as strong as your weakest link, and
3) Success lies in understanding, and optimizing, how each of the moving parts works in conjunction with the others, so the whole machine runs with maximum power and efficiency.
And this remains the same, whether you’re on the playing field or in the financial markets.
No Profit for One-Trick Ponies
Without the help of a coach, focusing on just one aspect of your game, like your grip, is detrimental to all the neglected elements… and ultimately your overall performance. The same goes for focusing on just one sector of the markets…
I’ve mentioned before a trading buddy of mine that only trades pharmaceutical stocks. He keeps a calendar of FDA trial dates and rarely looks outside his ultra-specific niche. He is a master of drug stocks, and aware of little else.
This makes it hard for us to have a conversation about investing. He yammers on about efficacy rates of cutting edge diabetes treatments, while I pontificate about the recent decoupling of stocks and bonds.
Basically, he’s talking trees while I talk forest… and we both just kind of listen and nod, only to be polite.
Admittedly, he has a one-up on me in his niche (just like the baseball player can pitch better than his coach). Yet his approach is far more dangerous…
He trades drug stocks without any understanding of how these are affected by changes in interest rates. He doesn’t know whether a strong dollar with hurt, or help, the U.S. multinationals he’s invested in.
Worse still, he’s unaware that the bond market can act as a leading indicator – sometimes giving six months (or more) in warning lead time – that a broad stock market decline is just around the corner.
Sure, he knows when Pfizer’s potential blockbuster is up for FDA approval… but will that matter much if the stock market’s about to crash anyway?!
We’re All in This Together
Think of the markets as parts of that baseball player…
There are four major asset classes in the global financial network: stocks (arm), bonds (hand-eye coordination), commodities (speed) and currencies (leg strength). As the global market is a closed system, there is a limited amount of money to be invested and a limited number of investments to bet on.
This means it’s unlikely all four asset classes go up together, or down together. It also means that some investments do better when the economy is expanding, others while it’s contracting.
In fact, many of the intermarket relationships I’ve referred to are fairly predictable. Here’s one example…
In most environments, stocks and bonds move with a positive correlation – meaning, they go up together and down together. At market tops, history has shown that bonds are typically the first to roll over.
Weakness in bond markets can last for many months, even as stocks continue to climb higher. Eventually though, falling bond prices are a warning signal that stocks are soon to turn down also.
Likewise, commodities tend to be the last market to crack. Well after bonds have fallen, and even as stocks have started to show weakness, commodities tend to surge higher. At this point in the business cycle, inflation is elevated, which works to push commodity prices higher. Plus, gold tends to spike at the tail end of a market top, as investors who have rushed out of bonds, then stocks, look to gold as a better alternative.
Knowing the order in which these asset classes form market tops is invaluable – it helps astute investors “look around the corner” and make decisions – like taking profits in long stock positions – well before the masses.
Of course, there are always exceptions to the rule…
The relationships between these four assets classes change, or evolve, over time. Deflationary environments, like we’re in now, actually cause the relationship between stocks and bonds to change dramatically.
Here’s a chart that shows the correlation between stocks and bonds going back to the early 1990s. Prior to 2001 there was a positive correlation between these markets. Yet after 2001, stocks and bonds “decoupled.” These markets are now inversely correlated, meaning when bonds go down, stocks go up.
See for yourself…
As I said, the financial markets are infinitely complex, with many intricate relationships that continually shift with time. Ignoring the global capital flows between stocks, bonds and commodities is akin to a Tour de France cyclist ignoring all but his legs.
That’s why, just like athletes who are serious about winning, as an investor who’s serious about making good money, you need a coach. Someone who sees all the elements and how they work together or against each other.
That someone is me.
You can just call me coach.