Option Investor
Trader's Corner

Relationships Between Different Indices and 'Markets'

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OIN SUBSCRIBER QUESTION
Just wondering if you could tell me what the relationship between different indices/commodities are. What is the significance of divergences between major indices if any? An obvious example would be oil vs. transports.

RESPONSE:
This is a complex and big subject. One on which I have not done a lot of research myself. John Murphy has, another technical analyst whom I know who is widely known in fact. John has written on this subject in his book "Intermarket Analysis", which is a broad study of the relationship between equities, bonds, currencies, and commodities. This is sort of a 'macro' view.

I am at times curious and interested in specific comparisons and a 'micro' view, such as the relationships between oil or gold versus specific indexes; e.g., the Dow Transportation Average (TRAN) versus crude oil futures.

Or, BETWEEN indices as you note, like comparing the Semiconductor index (SOX) and the Nasdaq 100 (NDX); or, between the Russell 2000 (RUT) and the S&P indices. My interest is primarily whether a commodity or index may be acting as a 'bellwether' for the major trading indexes like OEX, DJX and OEX, tipping us off that an advance or decline will continue, 'consolidate' or reverse its present trend.

Some relationships are NOT intuitive, easily understood or obvious. For example, you would think that RISING prices in crude oil would tend to cause the Transportation Average (TRAN) to FALL. That this would be an INVERSE relationship; i.e., they move in opposite directions.

Fuel prices are a major cost to railroads, trucking companies and especially airlines. If a substantial portion of a companies costs go DOWN, their profits should go UP; right? More money to the bottom line, rising earnings, will cause stock prices to rise.

If this reasoning is correct and there are not some other, less obvious SIGNIFICANT other factors, how do we explain the below chart: a comparison of crude oil (nearest futures) prices for the past year approximately AND the Dow Transports (TRAN).

Its immediately apparent, slightly helped by my up or down lines signifying the direction of the broad price trends, that the
TRAN transport stock average is often (mostly) going up when crude oil prices are ALSO going up; and, vice versa: when oil prices fell during this period, TRAN was also generally falling. Go figure!

It can be seen on the above chart that a fall in oil prices has been ahead ('led'?) a further rise in TRAN, such as was the case from early-Nov into late-Dec; but the direction of the overall trends have tracked each other for long periods of time. There are probably lagging effects, seasonal considerations, what the overall market is going, etc., that are also key.

While this is only a brief and recent comparison between crude oil and the Dow Transports, it's not like the obvious INVERSE relationship that tends to be the case for overall commodities prices (e.g., the 'CRB' index) and bonds. You can overlay these charts and see that bonds tend to RISE (yields fall) in price when commodity prices FALL.

Now, perhaps I have not had my thinking cap on long enough (or, am not smart enough) to figure any reason why this more 'direct' (not 'inverse') relationship would be occurring between crude oil prices and the transportation stocks. Perhaps someone reading this can hazard a guess or pinpoint why the various ups and downs are moving in the SAME direction. If so, please write in.

One point I want to make is that relationships between indices and key commodities are not so easy to figure. John, by the way, in his work, has done comparisons more between the overall commodity price index and equities and, especially, bonds.

COMPARISONS BETWEEN INDEXES: 'confirmation' and 'divergence'
The relationship between the Semiconductor Index (SOX) and the Nasdaq, especially the Nasdaq 100 (NDX) provides some useful confirmations or divergences at times. I wouldn't say that SOX is exactly a 'bellwether' index for the Nasdaq, in that it doesn't always move ahead of NDX.

But these two indexes do fill the useful role of confirming or not-confirming tops or bottoms; or, to alert us to a significant trend reversal ahead, extremely useful in terms of taking out major call or put option positions at various times during the year.

This is part of my 'less is more' theory of trading index options: the less you trade, the better, by taking only high-potential trades. Hey, you only need a few of these to make a very profitable year!

Looking at the SOX versus NDX charts below, what is often seen is that NDX will form a bottom or top first; e.g., a bottom in August '04, a top in late-Dec '05. The two bottomed at the same time approximately, this past April, thereby 'confirming' the trend change or reversal in each other, which was useful and somewhat unusual. Notice that the Nasdaq 100 didn't really get into a major uptrend UNTIL the SOX index finally bottomed.

In two instances SOX formed a 'strong' (in terms of predictive value) technical pattern with first a 'double top' and later a 'double bottom'. The double top was not only a 'sell signal' (buy puts) for SOX, but suggested that NDX was very likely going to continue to go lower. The double bottom in SOX was not only a solid 'buy signal' for SOX calls, but a MAJOR confirmation for the likelihood that NDX had also bottomed.

We don't have to look too hard to find why the semiconductors might show, at times, a more definitive buy or sell 'signal' for the Nasdaq 100, as semiconductor chip sales strength is so important in suggesting that technology stocks are and will be doing better by selling more products requiring semiconductor chips.

INDEXES ACTING AS 'BELLWETHERS'
The Russell 2000 Index (RUT) of mid to small-cap stocks, sometimes acts as a bellwether, making a move AHEAD of the S&P 500 index of (all) big-capitalization stocks; not so, the Nasdaq Composite and Nasdaq 100, as RUT trades in line with, not ahead of, the Nasdaq almost exclusively.

The charts below are weekly close-only 'line' charts, so the 'line' is not finished so to speak, until the Friday (weekly) close. In a weekly line chart, today's close is temporarily equal to the weekly close.

Back in 2000, the mother of all 'sell signals', was not only the weekly closing double top in SPX, but the quite pronounced divergence of RUT, as it failed to 'confirm' (by a country mile) a close that was anywhere near its prior peak. RUT was way ahead of the S&P here. Of course, any double top is a potent sell signal. The combination of RUT's price pattern and the SPX double top was a major confirmation of a major top.

The most recent instance of the Russell 2000 acting as a bellwether and 'leading' the S&P, was the decisive upside penetration of RUT's prior high some days ahead of SPX; enough so to make it useful for trading, by keeping to a bullish market outlook. Of course this story is not written or completed yet, in the S&P 100 (OEX).

Perhaps, more emphasis on this leadership role of the Russell would have kept me MORE bullish on my Nasdaq 100 (NDX) calls, not so ready to take my profit, since I've been unconvinced or unsure that NDX would ALSO make a new high for this year. Stay tuned on that! And, well, I always get out when I've captured a good part of a move and an index is near an old important peak. Let the other guys fight it out for a final potential spurt through an old high. But I digress!

The DAILY chart comparison of the two indexes (RUT + SPX) below, also tells an interesting story. First of all, it's easier to see the leading role of the Russell in breaking out to a new yearly high.

The other instance of where a divergence in the price action of the two indexes was very useful in trading (leading to a quite profitable index put purchase), was when the S&P 500 (SPX) went to a decisive new high, whereas the Russell 2000 (RUT) hit a decisively lower peak.

Of course, it remains to be seen whether RUT's strong move to a new high will also be a harbinger for the narrower S&P 100 (OEX) index or for either the Nasdaq Composite (COMP) or Nasdaq 100 (NDX), since neither has pierced its early-January high. I don't give AS MUCH weight to RUT leading to a new high or new low, per se, but more to whether it DOESN'T lead to a new high or new low. This pattern, this type 'divergence' is often a possible sign of a top or bottom, respectively.

Lastly and summing up on comparing different MARKETS and difference INDEXES, there is no often no simple formula for how comparisons between markets or between indexes will translate into what one market or index does versus the other.

Often, the relative performance or patterns of two 'RELATED' indexes (e.g., SOX and NDX) can tip us off to a trend reversal; OR, give us more to go on in staying in a position since there is are some added reasons or evidence for our course of action.

Good Trading Success!

NOTE -
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Contact Support with 'Leigh Stevens' in the Subject line.
 

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