Using Intermarket Relationships to Measure Risk-Appetite
SFO Magazine: Intermarket Analysis Offers Clues - Risk On!
Friday, June 8, 2012
By J.C. Parets
Today we’re looking at some intermarket relationships that represent risk appetite throughout the global markets. Usually, when someone asks, “So how did the market do this week?” they usually mean the Dow Jones Industrial Average or S&P500. The results in these averages are what you normally see in the headlines.
FOREX CLUES
But to really get an understanding as to whats happening in this market, and how market participants are behaving, we need to look elsewhere. First, I like to start out in the currency world.
How are risk-on currencies like the Aussie dollar doing relative to more risk-off areas like the Japanese yen? If the Dow and S&P are making fresh lows here in the states, these currency crosses should confirm the pessimism. When they don’t, we’re getting hints that things aren’t as scary as they may appear on the surface. And sure enough, with the S&P 500 and Dow Industrials hitting new 5-month lows, the $FXA:$FXY pair held its own and put in a higher low. These ETFs that represent the Currency Shares Australian Dollar Trust and Currency Shares Japanese Yen Trust are telling us not to panic.
BOND CLUES
Moving over to the bond market, a reliable gauge for risk appetite is the relative performance of High Yield (or Junk) bonds compared to the guaranteed return of the U.S. Treasury bonds. This particular ratio ($HYG:$TLT) also made new lows in early June as U.S. stocks rolled over, but momentum (RSI) in this pair has already turned up. The bullish divergence in momentum for this risk-on gauge is definitely a positive in the face of a potentially bearish confirmation in price.
EQUITY ACTION
Now in the stock market, fresh lows for the major averages should be confirmed with new lows in the Consumer Discretionary vs. Consumer Staples ratio. If market participants are truly as bearish as 5-month lows in the Dow & S&P may show on paper, then the internals of the market should confirm that.
But while fresh lows were made in the averages, the $XLY:$XLP ratio also held its own and put in a higher low. The Consumer Discretionary SPDR is loaded with retailers like $AMZN $SBUX $TGT and other areas where consumers spend their discretionary income like $F $DIS $MCD and $NKE. If the major averages make new lows, then these discretionary areas should also underperform the more defensive Consumer Staples SPDR which is filled up with cigarettes ($MO), Coca-Cola ($KO), Procter & Gamble ($PG) and other areas where consumers will spend money regardless of poor economic conditions.
These new lows in price for the Dow Industrials & S&P500 were not confirmed with new lows in the $XLY:$XLP ratio showing yet another bullish divergence. You see by looking at multiple asset classes like currencies, bonds, and specific sector rotations in the stock market, we can get a better idea as to what’s really happening out there. All of these measures of risk appetite are telling us that things are not so bad and that we should be looking to put risk on, not off.
STAY TUNED
Now keep in mind that new lows in these pairs would argue differently, so stay tuned.
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