How to Trade – Book Review – John Murphy, Intermarket Analysis

Most of the literature analyzing asset allocation that links multiple markets has a large dose of macroeconomics and microeconomics. Macro-micro relationships generally require the application of econometric models to understand the structural links between the two interlocking fields of the economy. John Murphy eliminates hard statistical methods while preserving economic logic with graph-based reasoning.

John Murphy was a CNBC-TV technical analyst for seven years and a professional analyst for more than 25 years. His career includes time at Merrill Lynch as Director of Commodity Technical Analysis. John has his own consulting firm, JJM Technical Advisors. He is also president of MurphyMorris, Inc., which was created to produce educational software products and online services for investors.

There are proper reader reviews on Amazon and Google Book Search, to help you decide if you will get the book. For those just starting out or about to read the book, I have summarized the core concepts in the most important and essential chapters to help you read them faster.

The number to the right of the chapter title is the number of pages that chapter contains. It is not the page number. The percentages represent the composition of each chapter of the 246 pages in total, excluding the appendices.

1. A revision of the 1980s. 16, 6.50%.

2. 1990 and the First Persian Gulf War. 16.6.50%.

3. The market for sneaky bears in 1994. 18, 7.32%.

4. The 1997 Asian currency crisis and deflation. 14, 5.69%.

5. Inter-market trends from 1999 leading to the top of the market. 16.6.50%.

6. Review of the principles between markets. 16.6.50%.

7. The NASDAQ bubble bursts in 2000. 18, 7.32%.

8. Image of the intermediate market in the spring of 2003. 16, 6.50%.

9. The fall of the dollar during 2002 boosts raw materials. 14, 5.69%.

10. Change from paper to hard assets. 14, 5.69%.

11. Futures Markets and Asset Allocation. 20, 8.13%.

12. Analysis between markets and the economic cycle. 20, 8.13%.

13. The impact of the business cycle on market sectors. 18, 7.32%.

14. Diversify with the real estate sector. 18, 7.32%.

15. Thinking globally. 12, 4.88%.

Focus on Chapters 3, 7, and 11-14, which make up about 46% of the book. Especially chapters 11 to 14 are relevant for practical business purposes. Unlike my previous book reviews, where I summarized the key points for each focus chapter, I will summarize the key points from chapters 3, 7, and 11-14. This is to recognize the connectivity of the relationships between markets across the 4 main asset classes of stocks (stocks), bonds, currencies and commodities. The context of the summary should be viewed from the perspective of a retail options trader.

Here are the key directional relationships between markets in brief.

The United States dollar (USD)

• The USD rises when bonds rise under normal conditions, but bonds fall during deflationary periods. The USD goes down when bonds fall, but bonds go up during deflationary periods.
• The USD rises as commodities fall. The USD falls as commodities rise.
• The USD rises as stocks rise, but stocks fall during deflationary periods. The USD goes down as stocks fall, but stocks rise during deflationary periods.

The USD remains the most liquid of all the major traded currencies and maintains its position as the world’s leading reserve currency, despite growing confidence in an alternative basket of currencies to replace it.

Captivity

• Bonds rise as the USD falls, but the USD rises during deflationary periods. Bonds go down as the USD rises, but the USD falls during deflationary periods.
• Bonds rise as commodities fall. Bonds go down as commodities go up.
• Bonds appear as stocks rise. Bonds lead stocks and stocks lag behind bonds. Bonds go down as stocks fall. Again, bonds lead stocks and stocks lag behind bonds.

Raw Materials

• Commodities rise as the USD falls. Commodities go down as the USD rises.
• Commodities rise as bonds fall. Commodities go down as bonds go up.
• Commodities rise as stocks fall. Commodities go down as stocks rise.

Stocks

• Stocks go up as the USD rises. Stocks go down as the USD falls.
• Stocks go up as bonds go up. Stocks go down as bonds fall. Again, bonds lead stocks and stocks lag behind bonds.
• Stocks rise as commodities fall. Stocks go down as commodities rise.

For equities specifically, when trading options on the S&P 500 industry indices, consider correlation versus no correlation with other equities and non-equities traded products. I am stating briefly, the most commonly known relationships that are repeatedly elaborated in the book:

• Changes in energy (XLE), especially in oil (OIH, OSX), affect semiconductors (SMH, SOX).
• Utilities (XLU, UTH, UTY) are negatively correlated with semiconductors (SMH, SOX).
• With broad-based equity indices, the highest correlation is between the Dow Jones and the S&P 500.
• Canada benefits from rallies in oil by being the world’s ninth largest producer of crude oil. While Japan, a major net oil importer, suffers. The tickers for this interaction would be FXC / XDC (Canadian dollar), FXY / XDN (Japanese yen) and OIH / OSX (oil).
• Gold (XAU, GLD) behaves like the Australian dollar (FXA, XDA). Australia is the world’s third largest producer of gold.
• The three major currencies that have the closest correlations with commodities are the Australian dollar, the Canadian dollar, and the New Zealand dollar.
• Gold / Silver (XAU, GLD) has very little correlation with other indices.

A deeper understanding of these interactions can help you build effective peer negotiation methods.

In conclusion, from a retail options trader’s point of view, always remember that what you are trading is volatility. To trade volatilities across multiple asset classes, use an optional index that represents that particular asset class. Remember, implied volatility can be added to or reduced from your portfolio, as not all asset classes or sectors or individual companies or countries ALL go up or down in value ALL at the same time; and / or ALL at the same rate.

 

This is not a criticism of the book, but a personal observation. It does not address the use of relative strength as a mechanism to cyclically enter or exit an asset class, as one asset class weakens or strengthens against another asset class. I have written about relative strength in another article, titled “Stock Option Trading: Fundamental Flaw in Fundamental Analysis and Stock Selection.” Please read it as a supplement to this article.