Link Between Stocks, Mutual Funds and Futures: Intermarket Analysis

The basic premise of inter-market analysis is that all financial markets are linked in some way. That includes international markets as well as domestic ones. Those relationships may shift on occasion, but they are always present in one form or another. As a result, a complete understanding of what's going on in one market-such as the stock market-isn't possible without some understanding of what's going on in other markets. Because the markets are now so intertwined, the technical analyst has an enormous advantage. The technical tools can be applied to all markets, which greatly facilitates the application of inter-market analysis. You'll also see why the ability to follow the charts of so many markets is a tremendous advantage in today's complex marketplace.

INTERMARKET ANALYSIS AND MUTUAL FUNDS

It should be obvious that some understanding of these inter-market relationships can go a long way in mutual fund investing. The direction of the U.S. dollar, for example, might influence your commitment to small cap funds versus large cap funds. It may also help determine how much money you might want to commit to gold or natural resource funds. The availability of so many sector-oriented mutual funds actually complicates the decision of which ones to emphasize at any given time. That task is made a good deal easier by comparing the relative performance of the futures markets and the various stock market sectors and industry groups. That is easily accomplished by a simple charting approach called relative strength analysis.

PROGRAM TRADING: THE ULTIMATE LINK

Nowhere is the close link between stocks and futures more obvious than in the relationship between the S&P 500 cash index and the S&P 500 futures contract. Normally, the futures contract trades at a premium to the cash index. The size of that premium is determined by such things as the level of short term interest rates, the yield on the S&P 500 index itself, and the number of days until the futures contract expires. The premium (or spread) between S&P 500 futures over the cash index diminishes as the futures contract approaches expiration. Each day, institutions calculate what the actual premium should be called fair value. That fair value remains constant throughout the trading day, but changes gradually with each new day. When the futures premium moves above its fair value to the cash index by some predetermined amount, an arbitrage trade is automatically activated-called program buying.

When the futures are too high relative to the cash index, program traders sell the futures contract and buy a basket of stocks in the S&P 500 to bring the two entities back into line. The result of program buying is positive for the stock market since it pushes the S&P 500 cash index higher. Program selling is just the opposite and occurs when the premium of the futures over the cash narrows too far below its fair value. In that case, program selling is activated which results in the buying of S&P 500 futures and selling of the basket of stocks. Program selling is negative for the market. Most traders understand this relationship between the two related markets. What they don't always understand is that the sudden moves in the S&P 500 futures contract, which activate the program trading, are often caused by sudden moves in other futures markets-like bonds.