Intermarket Analysis & Economic Forecasting

Article excerpt

Using intermarket analysis and Elliott wave patterns, we can better forecast turns in the economy. This can lead to better predictions of major shifts In tradable markets.

Markets do not exist in a vacuum and neither does the economy. The two are undeniably linked, and if we can discover better ways to forecast the latter, we can expect to improve trading strategies for the former.

In this first of two parts, we will discuss how we can use intermarket analysis and economic data to forecast interest rates and the possible direction of the economy. Not only is better economic forecasting valuable to the small business owner on Main St. but, more important to us, it can play an integral part in improving economic-based trading strategies.

At best, traditional economic forecasting has an unfavorable track record. However, there are economists who are almost never right in their analysis, yet their time as consultants is paid for dearly by hedge funds managers. But the tide for economic forecasting is quietly changing. Many large corporations now use intermarket analysis in their forecasting models. With several simple tools, individual traders can employ these same new techniques and even generate better forecasts than the so-called gurus.

Developing economic forecasts might be unfamiliar to many traders, either because they focus on just the technicals or consider it ancillary to the markets. But it is important, and this article will show why. To that end, we need to discuss several core topics that are needed in our analysis. These areas include:

1. How the bond and equity markets interact with the business cycle;

2. Understanding how the yield curve affects the economy;

3. How Elliott wave analysis can be used to analyze the economy;

4. How forecasts and news items affect the markets and the economy.

The business cycle Throughout history, the economy of the United States has undergone repeated boom and bust cycles. Sometimes, these cycles have moved to extreme levels like the Great Depression of the 1930s, the hyperinflationary 1970s and the great economic expansion of the 1990s. Normally, the business cycle is about four years in length, but sometimes the cycle will expand during times where large structural advancement is made.

Examples of business cycle expansion would be the Industrial Revolution of the 1920s and the beginning of popularization of the Internet and productively age of the 1990s. Often, during these longer periods of rapid economic growth, economists will get excited and say something to the effect that this time things are different and that there will be no economic contraction. But nothing so fundamental ever really changes, only the timing of the business cycle. To understand how intermarket analysis can be used to forecast the economy, we need to have a basic understanding of how the business cycle works (see "Intermarket cycles," left).

During the acceleration phase of an economic expansion, bond prices begin to turn down because of the underlying fear of inflation. Lower bond prices represent higher interest rates and after a time, consumers feel the pressure of higher interest rates on their ability to spend money. This is bearish for stock investments, and a downturn in stock prices occurs. Higher interest rates and inflationary pricing cause people to buy fewer goods on time, and the resulting slowing of economic activity serves to hurt corporate profits.

The downturn in stock prices will start about six months before we begin to see a turn down in the general economy. After the economy has moved into recession, bond prices again will lead the way by beginning to rally six to eight months before the economy actually begins to turn back up. After bond prices begin to rally, stock prices will follow.

If we can understand the dynamics of how bond prices and stock prices are interrelated with the economy on a broad scale, we can use their general price activity to predict the direction of the economy. …