The reliability of intermarket analysis is dependent on an absence of external distortion. Recall that intermarket relationships broke down with currency intervention following the Thai Baht crisis in 1997 and liquidity intervention following the financial crisis in 2008. As the impact of QE intervention subsides, we look to intermarket relationships reasserting themselves. Both inflationary and deflationary signals are present, with a recent tilt towards deflation.
Through 2011, asset prices rose together under QE, and this was the inflationary intent of the Fed. The key for deflation is that stocks and bond prices move inversely, while the dollar could be up or down. At present, the resurgent dollar is bullish for bonds and weighs on already weak commodities. Since the 2011 peak in the CBOE’s cross-asset correlations with the S&P 500 (>86%), performance is dispersing, and we read this as a decreasing appetite for risk.
It is rare that all the signals align, especially across different time frames. For instance, since 2011, commodities support the deflationary theme. Investors concerned about broadening deflation should watch for a positive correlation between commodities and stocks (lower). For now, base metals are on the decline, precious metals are recovering, or consolidating o a longer-term basis. Its worth remembering that the former is more demand driven, the latter driven by to both demand and currencies.
The chart below gives us a more practical application of intermarket analysis, giving us a view to forces below the surface. The price line describes the relationship between stocks and bonds (SPY/TLT). The decline beginning January 2014 supports increasing risk aversion, similar to widening credit spreads. This decline is broadening, which describes growing disagreement in the crowd as to the relative value of each. Successive rallies in stocks at the expense of bonds have grown weaker. The trading environment is further complicated by trendline resistance intersecting a key Fibonacci retracement level (61.8%) near 1.68. Statistically, this structure most often breaks out to the upside (~79%) but the timing is uncertain. While price action in the SPY is outwardly bullish and internals are generally positive, the SPY/TLT data suggests impediments to a stronger breakout. Seasonality also points to some consolidation prior to a stronger March, which coincidentally is when the ECB’s turn at quantitative ease begins.
In sum, the long-term advance appears intact, the medium term is in transition due to a lack of clarity in the short-term. What appears to be more likely, is that the market follows the script of the last few years, advances become extended, shallow affairs, interspersed with corrections that throw everything into question until we are reminded that there are yet no alternatives to equities. Raise the Risk-On flags.
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Managing Director, Chief Market Strategist