The Futures / Inter Market Report

Trading the World’s Markets                            

June 1, 2007

                                            
Matthew Caruso, CMT                                  
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Study of Current Market Sentiment

    Intermarket signals can be of great importance in determining the future direction of market prices. In this column we have seen multiple intermarket relationships; such as the typical pattern of the Russell 200 underperforming the Dow Jones near tops. It is important that intermarket relationships truly represent changes in market sentiment, or truly show a change in conditions for another market. What I mean by this is that when the Russell underperforms the Dow it is showing that investors prefer stocks which are more stable and have less growth potential, this shows the underlying risk preference of investors and therefore indirectly their sentiment. Falling bond prices which coincides with rising yields is often a precursor to a stock market top because higher yields offer stock investors an opportunity to make a higher return with a lower risk in another market and causes selling pressure in stocks. Such intermarket relationships are unlikely to be disturbed in the long run, of course over the short term any relationship can break down.

    It is important to follow market conditions so that you can know when a market approach is no longer valid. Markets aren’t static, they change and evolve and good methods of the past are not always good in the future. It is the job of the investor to monitor the tools that he uses in order to detect when his tools are becoming outdated. In the 4th edition of Martin Pring’s book he presents the General Motors (GM) intermarket relationship. The premise of this approach is that given the size of GM and the number of employees it employs, any changes in GM will be a by  the U.S. economy as a whole. This relationship worked well for many years as can be seen in figure 1, which is similar to what Martin shows in his book.  It is very apparent from this chart that GM was a very good market indicator. New highs in the S&P 500 that were not confirmed by GM developed into tops, and new lows in the S&P 500 not confirmed by GM developed into bottoms.




Figure 1

Someone witnessing the good performance of GM as a market indicator in the 1990s probably wouldn’t anticipate the poor performance of GM as a market indicator in the current bull market.  Figure 2 shows the same chart but for the current time period. GM fell all throughout 2004 and 2005 while the S&P 500 charged higher. When GM turned up in early 2006, the S&P 500 fell. GM failed to make new high after the February correction, the S&P 500 charged higher once again.


Figure 2

    What happened here? Are other intermarket relationships apt to fall apart as this one did? What happened is that GM is not the same company it used to be, in fact the American Auto industry is not what it used to be. GM is the only American auto manufacturer to still be larger than Toyota, and that is most likely to change as well. Simply, GM faces more competition, is less profitable, and less representative of the U.S. economy and therefore of the U.S. stock market as well. Other intermarket relationships are not as susceptible to break down as the GM relationship did. One way to measure the strength of a relationship is know what it would tae for the relationship to fail. In the case of GM, anything that would affect the company’s status in its industry or the company’s size would alter its predictive ability. In another example, the intermarket relationship between the Russell 200 and the Dow discussed earlier is unlikely to change since it based on a large basket of stocks and no single market shock to a company will change the overall relationship. As Martin Pring mentions in his book, this relationship is another technical tool which should not be used in isolation but in conjunction with others. An approach using multiple indicators would have unlikely been affected by the breakdown in the GM – U.S. stock market relationship.