Intermarket Analysis for Retail Stock Market Investor

Why Does an Equity Investor Need To Know About Other Asset Classes?

The knowledge of intermarket relationships, can get you early warning signals or confirmations about the trend.

Lets understand this through an example, gold is said to be inversely related to stocks. Therefore if you think the economy has entered Phase I (remember Business Cycle?), and feel that demand would come back and hence equities should be the favoured asset class. Alternatively, you may have seen a break out in the Nifty 50 index chart and feel that it will trend higher. A confirmation of this can be seen with sideways or down trend in the gold prices. When you have gotten a confirmation about your thesis, it generally has a lower failure rate and you can allocate higher towards equities or pull out/short gold.

Once you are aware of why to use intermarket analysis in your investment or trading decisions, let's now move on to see the factors affecting equity markets.

Factors Affecting Equity Markets

1.Corporate Profits

A stock price is derived by multiplying the earnings per share to the Price to Earnings Ratio (EPS * PE = Stock Price). 

While many of us would believe that the prices of most quality companies have been possible only due to PE expansion, let's look at the following data to confirm our thesis.

The table shows the return breakup of the price change. The Times change in PE * Times change in EPS is approximately equal to the Price Change (Times). 

Let's interpret Kotak Mahindra Bank’s (Kotak) return. Kotak’s share price has risen 756 times over the last 20 years. Out of this a 67 times of rise was due to EPS expansion and the remaining 12 times was due to PE change.

Similarly, it can be seen that for the top 10 quality companies, the EPS change has been a more dominant force than the PE change. 

Hence, corporate profits can not be neglected as a major factor driving the returns of equities.

2.Market sentiment

Another important factor determining the stock returns is the market sentiment. An estimate of the market sentiment can be taken through the PE expansion or contraction. A PE expansion of a stock is generally seen as a positive sentiment and hence drives the stock price higher. A PE contraction on the other hand can be seen as a sentiment damper and hence drives the stock price lower.

Technical analysis can also be used to judge the market sentiment.

3.GDP growth rate

Companies work within the nation and mostly cater to the demand of the nation. Hence it is obvious to note that if the nation grows, so will the company's profits and consequently the market cap. The scenario of higher GDP growth rate is witnessed during Phase I to Phase II of the business cycle.

Hence there is a positive correlation between GDP growth rate and stock prices.

4.Inflation

Inflation is surprisingly positively correlated to the equity returns. However, the correlation is not symmetrical. See the following table:

(Source: https://fred.stlouisfed.org/series/INDCPIALLAINMEI)

R squared is the correlation coefficient signifying the strength of correlation between two variables. The value of r squared ranges between +1 to -1. A positive number signifies positive correlation whereas a negative number would suggest that the two variables move in opposite directions.

Here, we have the 20 year correlation between the inflation (CPI - India) and annual returns of Sensex, Hindustan Unilever (HUL) and Tata Steel are calculated. 

It can be seen that although all these have a positive correlation with inflation, however, the degree varies between Tata Steel and HUL. 

Tata Steel directly sells the commodity products that are iron and steel and gets benefited through higher prices. 

HUL on the other hand may or may not benefit. It will only benefit through inflation if it is able to take a price increase higher than the increase in prices of its raw materials.

When inflation rises above the desired levels, chances of an equity market downfall increases. This was experienced in 2008 when RBI’s inflation target range was 5.1-6.2% during the start of 2008

(https://www.rbi.org.in/SCRIPTS/PublicationsView.aspx?id=11302) and when the actual inflation numbers crossed  8.35%, a severe fall in the equity market was experienced with Sensex falling 52% during that year.

It has been witnessed that during Phase I and II, inflation growth is in the healthy range and hence supports equities.

In a broader sense, inflation which is within the Central Bank’s target range gives a boost to equities and vice-versa.

5.Interest Rates

Interest rates play dual roles in defining the stock returns:

a.Interest rate influences the cost of borrowing for the company. A higher interest rate causes the loans to get costlier and hence affects the solvency of the firm. On the contrary,  a lower interest rate boosts the profits of the firm as the interest expense reduces.
b.Interest rate is an important tool in calculation of the intrinsic value of a company through discounted cash flow analysis. A lower interest rate boosts the value of the firm and hence results in an increase in the share price.

From the above two roles, it can be concluded that stock prices are inversely related to interest rates. 

However, one with the knowledge of business cycles can argue that Phase I and II corresponds with an increase in interest rates and stock prices both. Hence, the interest rate factor should not be seen in isolation and should always be connected with other factors like GDP growth rate and inflation. 

This complexity can be solved when one understands the drivers of interest rate. As explained earlier, interest rate is the sum total of GDP growth rate, inflation and the central bank's monetary actions (a plug-in figure). In understanding the role of interest rates on stock markets, the following thumb rule helps.

If the effect of GDP growth rate on interest rate is higher than inflation, we are in Phase I-II of the business cycle and hence equities will rise. 

If the effect of inflation on interest rate is higher than GDP growth, we are probably in Phase III of the business cycle and hence equities shall fall.