Introduction
Traditionally, an equity investor is taught to focus on either fundamental analysis of the company or technical analysis or both in order to find the right opportunity. However, earlier due to scarcity of information, this was sufficient to generate good returns.
Presently, the information is abundant. It is difficult to generate an alpha (higher return than the benchmark) by just focusing on fundamentals or technicals. Intermarket analysis equips traders & investors with the extra edge to beat the index.
Similarly, market manipulations are higher in the equity markets and affect the retail investors specifically. With the knowledge of intermarket relationships, you can get early warning signals or confirmations about the trend.
What is Intermarket Analysis?
Financial markets comprise four main asset classes: Stocks, Bonds, Currency and Commodity. The movement of each asset class has an impact, positive or negative on other asset classes. When you are analysing the science behind this relationship and utilizing the same in order to make your investment decisions, you are said to be doing an “Intermarket Analysis”.
Intermarket Analysis as a branch of Top-Down Approach
Intermarket analysis is a branch of Top-Down Analysis, so let’s first understand the different types of analysis, before delving deeper into the Intermarket Analysis.
Fundamental Analysis comprises of two branches of studies:
1.Top-Down Analysis
2.Bottom-Up Analysis
Both the approaches have a similar end result, i.e., investing in the ideal opportunity. However, the only difference is the sequence of study. Let’s understand this through the following infographic.
A top-down investor will do the majority of her research on the macro-economic indicators such as GDP growth rate, inflation or unemployment data, to reach a conclusion about the state of the global and domestic economy and conclude whether the time is optimal to allocate capital or not. Well, this is not all, once the state of the economy is defined, the top-down investor will select the most appropriate sector that can outperform the market. Once the majority of the work with respect to the macro analysis is completed, investors would move towards selecting a portfolio of stocks that best meets her criteria of investments. A good example of top down investment is when you select a thematic fund. A thematic fund is a mutual fund that own stocks that are selected on the basis of a particular theme. Say, you are bullish on the consumption pattern in India. In that case, you may select consumption funds provided by many asset management companies (AMCs). The NAV of the fund will go up as the consumption in India grows.
A bottom-up investor, on the other hand, would spend most of her time selecting the best stock and then move up the ladder to justify the purchase. For example, a bottom-up investor picks up Infosys as a prospective investment opportunity by looking at its fundamentals in detail and valuing the company. She would then move up the ladder in order to understand the economics of the sector, country and global economy.
A top-down investor would generally hold a more diversified portfolio than a bottom-up investor due to a lower focus on individual stocks.
Investors using the top-down approach, in-order to make sense of the fluctuation in the broader factors like GDP growth, inflation, interest rates, etc. have formed a template model called the Business Cycles and divided it into four different phases as shown below.
Therefore, each business cycle comprises four phases oscillating the economy between the booms (peak of Phase II) and recessions (trough of Phase IV).
We will discuss more on business cycle & Intermarket analysis in our next section.
