Review: Intermarket Analysis and Investing

“Recognizing that the stock market is a difficult game to play and admitting that investing in securities is an art, we can only preface this book by saying, ‘Good luck.’”

So writes Michael E.S. Gayed in the forward to Intermarket Analysis and Investing, originally published in 1990 and republished in 2013.

Outside of politics, few areas of life are in greater need of fresh thinking than the investment profession.    Like students of political ideologies or religious cults, investors often fall into dogmatic camps.  There are chartists, who view stock patterns as if they are prophetic views of the future.  There are value investors who view the utterances of Warren Buffett and Benjamin graham like divine revelations.  There are trend followers…and contrarians who actively bet against the prevailing trend.

There is a dedicated core of followers for virtually any investing style you can imagine (and plenty that you can’t).  But the problem with rigid schools of thought is that what works in one market does not necessarily work in another.

This is the basis of Gayed’s book.  Rather than lean too heavily on one particular method, with all of its inherent flaws, Gayed attempted to meld the various schools of thought into a unified process.  He’s not the first analyst to do so, and he certainly wasn’t the last.  But his attempt is one of the most comprehensive I’ve seen, and it was made over 20 years ago.

Investment books tend to have a somewhat finite shelf life.   Stories and anecdotes can look somewhat dated with the passing of time.  But as with Graham and Dodd’s Security Analysis, first published during the pits of the Great Depression, there is value in studying historical anecdotes and in reading a contemporary account of the times.  History tends to get “scrubbed” with the passing of time, which makes learning its lessons more abstract and difficult.  Gayed’s book fits a particular time period—the late 1980s and very early 1990s—making it an effective time capsule of the era immediately preceding the Internet Revolution.

One of the aspects I most respect about Gayed’s work is that he is intellectually honest.  Investing isn’t easy, and no “how to” book is a guarantee of success.   You will make mistakes along the way, but those mistakes make you a better investor if you make analyzing them part of your process.

And this is really the key word: process.  All 484 pages of the book can essentially be boiled down to one critical point: you must have a rigorous investment process in place.  The process can take different forms, but a regular assessment of the results should be a key part of it.  Process brings order from the chaos and prevents your investment decisions from being “a random walk of trial and error.”  And if it is failing to deliver results, “perhaps the whole process should be examined to uncover where things went wrong.”

Well said, Mr. Gayed.

Gayed addresses the strengths and weaknesses of each of the major schools of investing thought.  For example, of fundamental analysis he writes that it is “more reliable than any other approach…tangible and logical.”  But also acknowledging its shortcomings, he notes that “fundamentals tend to lag behind the price action.  The discounting mechanism of the market often senses evolving financial problems before the company actually discloses them.”

Similarly, Gayed notes that quantitative market timing approaches are “most helpful in allowing investors to buy or sell a security at the most opportune price.”  But they can also let you “get carried away in a frenzy of speculation and overtrading, eventually becoming a gambler.”  And remember, Gayed wrote this in the days before discounted internet trading and algorithmic bots!

I liked Gayed’s comments on contrarian investing because I see some of my own psychological shortcomings in his words.  While betting against the crowd at key moments can by wildly profitable, “The crowd is not wrong at all market junctures… The only correct application of the contrarian approach occurs when market psychology reaches unanimity in either direction.  Beware of being a contrarian all the time, since this attitude violates the well-established norms of trend following.”

Given my experience of working with Harry Dent for the better part of a decade, I found Gayed’s comments on demographics to be particularly interesting.  Dent made several bold predictions that proved to be correct and became a very successful New York Times bestselling author in the early 1990s by using demographics as a forecasting tool.  I still consider his first bestseller—1993’s The Great Boom Ahead—to be his best.

Dent is widely considered to be the first analyst to effectively use demographics in the investment process.  But Gayed appears to have independently reached many of the same conclusions at around the same time:

All industry groups are affected in varying degrees by demographics.  Beginning in the 1970s, the economy has felt the impact of the baby boomers—those born between 1945 and 1960… The influence of demographics is likely to continue into the first quarter of the next century as the baby boomers grow older.  There might be increased demand for such services as health care, banking, investments, insurance, nursing homes, leisure, travel, etc… Demographics should be factored into the overall investment strategy.

This could have been written today, but Gayed wrote it in 1990.  The prescience is impressive.

Gayed saves some of his best insights for last in the section on intermarket relationships.  The capital markets are a complex organism.  “Market links are interrelated, and they tend to feed on each other… The commodities market, for example, influences the trend of interest rates, which affect the bond market.  This, in turn, impacts securities prices.”

In this era of central bank intervention, it’s important to remember not to view each segment of the market in isolation.  Intermarket analysis is complicated…and messy…and you won’t always put the pieces together.  But it should be part of the thought process that goes into your asset allocation.  Gayed notes that an astute investor would have seen that the accelerating inflation of the 1970s would have been great for commodities but terrible for bonds.  But when the Fed’s high interest rates in the 1980s halted inflation, the high real interest rates in place set the stage for a long-term bull market in bonds…which in turn led to a long-term bull market in stocks.

I would add that more recently, investors with a deeper understanding of intermarket dynamics would have known that the Fed’s explosive growth in its balance sheet would not be inflationary given the debt deflation going on in the private sector. First order thinking would tell you to expect inflation.  Second order thinking would tell you to expect flat or even falling prices.

Oh, and remember “TED spreads”?  These are the spreads between Treasury bills and Eurodollar rates that become front-page news during the 2008 meltdown when the capital markets ceased to function.  Few people had ever heard of TED spreads prior to 2008.  Gayed was writing about them in 1990.

I recommend you pick up a copy of Intermarket Analysis.  Gayed’s magnum opus is an exhaustive collection of investment insights that he has done a remarkable job of funneling into a cohesive framework for analysis.   The sheer scope of material covered would put most MBA programs to shame.

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