Cybernetic Trading Strategies: Developing a Profitable Trading System with State-of-the-Art Technologies

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Classical Intermarket Analysis as a Predictive Tool

WHAT IS INTERMARKET ANALYSIS?

Intermarket analysis is the study of how markets interrelate. It is valuable as a tool that can be used to confirm signals given by classical technical analysis as well as to predict future market direction. John J. Murphy, CNBC's technical analyst and the author of Intermarket Technical Analysis (John Wiley & Sons, 1991), is considered the father of this form of analysis. In his book, Murphy analyzes the period around the stock market crash of October 19, 1987, and shows how intermarket analysis warned of impending disaster, months before the crash. Let's examine some of the intermarket forces that led to the 1987 stock market crash.

Figure 1.1 shows how T-Bonds began to collapse in April 1987, while stocks rallied until late August 1987. The collapse in the T-Bond market was a warning that the S&P500 was an accident waiting to happen; normally, the S&P500 and T-Bond prices are positively correlated. Many institutions use the yield on the 30-year Treasury and the earnings per share on the S&P500 to estimate a fair trading value for the S&P500. This value is used for their asset allocation models.

T-Bonds and the S&P500 bottomed together on October 19, 1987, as shown in Figure 1.2. After that, both T-Bonds and the S&P500 moved in a trading range for several months. Notice that T-Bonds rallied on ...