Using Ratio Analysis To Uncover Intermarket Relationships

Bo Harvey is writing today’s column.

As I indicated last Monday, I will look at one way that you can use ratio analysis to uncover intermarket relationships.  By this I mean the positive or negative correlations that may exist between different asset classes, the main four being stocks, bonds, commodities, and currencies. 

By plotting the chart of a ratio, you are basically able to see the strength or weakness of one asset relative to another—if the ratio is rising, then the asset which you have plotted as the “numerator” is outperforming the asset which is the “denominator;” if the ratio is falling, the reverse is true. 

Let’s look at an example, that of the yield on the 30 year T-bond vs. the 3-month T-bill.  This chart is basically telling us whether the yield spread between the two is rising or falling.  As you can see from the weekly chart below, the spread has been steadily rising until recently (I have used a line chart for simplicity’s sake):

Now, let’s quickly compare this to the chart of the HUI (Gold Bugs) Index:

A very solid correlation can be seen—in fact, the topping process in both the HUI and the yield spread, while not exact on a daily basis, has played out very similarly.  This gives us insight into the intermarket relationship being priced in right now, and for the gold stocks to build a base at these levels the yield spread will have to stop contracting.  This is one way that knowing the relationships a particular asset (or sector) has with another can add another useful indicator to your bag of trading tools.  One caveat: intermarket relationships such as this are best viewed on a longer time frame—personally, I have found that on a shorter day-to-day basis correlations such as this can be spotty and even downright useless for short-term intraday trading.  The longer time frame allows for more “time-slack” for these to play out.  

Speaking of gold stocks, I continue to use the several convergence and confluence levels that held in the XAU Index as my stop and risk levels.

I continue to be amazed when several technical levels such as this come together in synch—in this case an uptrend line, a Fib level, the 200 week EMA, and the apex of the triangle the index broke out of in 2003.  I continue to go light, however, since the index is approaching its declining 200 day moving average, and could very well retest these support levels again before a resolution takes place.

Have a great week,

Bo