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Exploring Intermarket Relationships: The Stock Market and Commodities

By Ellie Parkinson, Market Analyst turned Freelance Financial Writer 
 
Let's face facts; the global financial market is a huge entity that has a number of diverse derivatives, assets and niches. Not only is the financial market a vast and constantly evolving entity, but it is also a confusing one that requires traders to develop tremendous levels of knowledge, insight and determinism if they are to be successful. 
 
When building such knowledge, one of the most important steps is for traders to understand the intermarket relationships that exist and how alternative markets interact with one another on a daily basis.  
 
While this may seem daunting, it is interesting to note that there are some markets which have a more obvious correlation between one another. Take the stock market and commodities, for example, which have a unique and seminal relationship that can help traders to effectively manage their real-time trades. 
 
In this article, we will explore this in greater depth, while determining how traders can leverage this relationship to their own advantage. 
 
Stocks and Commodities as Individual Concerns 
 
Let's start with the basics, as stock and commodity exchanges share the fact that they are open platforms that allow the sale and procurement of assets through a variety of vehicles. They are also globally accessible and popular marketplaces, which traverse a multitude of industries including agriculture and manufacturing. 
 
There are differences between these two entities, however, which set them apart and enable traders to effectively diversify their portfolios over time. 
 
In terms of stocks, these are considered as equity shares through which traders purchase a piece of a specific company. This equates to a specific value, while such an investment arrangement is referred to commonly as equity ownership. Corporations raise funds and capital by selling a fixed amount equity through the financial market, allowing traders to invest in a theoretically safe store of wealth that requires them to assume ownership of the underlying asset. 
 
Conversely, commodities are part of a far more liquid and flexible exchange that offers investors access to a host of potential products. Through this vehicle, traders can buy or sell futures, derivatives and corporeal commodities according to their strategy, meaning that there is flexibility in terms of how they profit from their orders. As a largely derivative-based market, the commodity exchange makes it possible for traders to profit even as prices depreciate, by empowering them to speculate that demand or interest will fall within a set period of time. 
 
There are also a growing range of commodities to invest in the modern age, particularly as technology advances and drives significant change across the globe. Many new products will sit alongside traditional raw materials such as oil, cotton and coffee, creating an increasingly diverse exchange that is more accessible to a wider range of traders. It is also interesting to note that commodities exchanges have existed since the beginning of time in one form or another, with various materials used to barter or available for purchase in even primitive civilisations. 
 
As we can see, the commodities exchange is a longer-standing and more liquid entity that offers far greater diversity that stock exchanges. The latter offers a little more security in the current climate, however, meaning that both can be used as part of a balanced trading portfolio.  
 
The Relationship Between Stocks and Commodities  
 
While both markets are stand-alone entities in their own right, however, they have a clear and holistic interaction that has evolved over time. In simple terms, stocks relate to companies that often buy and sell products, many of which are also available as asset classes to commodity traders. This often means that investors have considerable choice when determining how best to capitalise on specific macroeconomic trends that have a direct impact on industries and the core products that define them. 
 
In a climate where oil prices were rising amid increased demand, for example, you may decide that you are better served by investing in company stocks that offer a corporeal and long-term store of wealth. Conversely, those hoping to capitalise on falling prices and a climate in which overproduction has created an excess of supply will only be able to profit by speculating that the commodities price will depreciate further. This is a scenario that has played out in the recent climate, as despite various measures being taken by the OPEC supply has continued to outstrip demand while prices have sunk to just $52.39 per barrel. 
 
This fundamental rule creates predictable cycles within both markets, causing them to react to another in a generally universal way. This is explored further by the 10-year monthly ETF chart below, which reveals that U.S. stocks and commodities tend to move in opposite directions. This trend is reflected in service driven economies such as the UK, while it has become particularly pronounced since the Great Recession in 2009. Since hitting rock bottom in 2009 and consolidating for a two year period beyond this, the markets have diverged strongly as stocks have soared while commodity values plummeted. 
 
 
 
A broad interpretation of this is that the global markets saw the financial economy (represented by stock options) rally as real economy and corporeal economy products such as commodities were sold off by risk-averse traders. While there is some level of truth to this, of course, the service-oriented nature of the American economy also had a seminal bearing on these numbers and drove results that were slightly disproportionate.  
 
More specifically, there are circumstances in which stock prices can mirror the trajectory of commodity values. In the case of advanced industrial economies that are largely commodity-based (think of Canada or Australia, for example) the correlation between the real economy and the demand for raw materials is far more pivotal. In short, commodities are the primary drivers of growth and financial market activity in these regions, meaning that share and commodity prices shares a far greater affinity. 
 
So while both Australia and Canada saw similar stock rallies to the one in the U.S., share and commodity values have since moved down in unison since 2014. This is a significant factor in determining the complex and changeable relationship that exists between stocks and commodities, as it tends to vary wildly depending on location and the nature of each nation's economy. 
 
As we can see, there is usually an inverse correlation between commodities and the stock market. This is typically the case in service-driven economies, while it has also become increasingly commonplace in an age of economic stimulus measures and financial economy growth. There are also numerous exceptions to this rule, however, with industrial economies driven by commodity price (and demand) and therefore more likely to see growth trends replicated across both types of exchange.  
 
Similarly, service-driven economies may also see a similar trend on certain occasions. Times of austerity offer a relevant case in point, for example, as demand for both stocks and commodities decline while investors adopt a risk-averse approach and seek out secure stores of wealth (such as gold or the Japanese Yen). 
  
We may also see U.S. stock and commodity prices mirror each others' trajectory in the coming year, as President Donald Trump pushes ahead with his proposed $1 trillion infrastructure plan. This would require a huge investment in natural resources and raw materials, driving higher demand and causing commodity prices to soar incrementally. This, in turn, attracts investors, and more specifically those who are primarily active in stocks and bonds. Over time, this will alter the inverse correlation between commodities and the movement of the stock market, creating a similar trajectory that will last for the duration of the project. 
 
The Bottom Line 
 
While the connection between stocks and commodities may seem obvious on some levels, it is deceptively complex and varies according to economic, geographical and macroeconomic factors. The relationship between these two entities is noticeable different when comparing service-oriented and advanced industrial economies, for example, while countries that invest in large infrastructure projects will also notice stock prices begin to mirror those of commodities.  
 
Such complexity can be challenging for an investor, which is why understanding the correlation between the two entities is so important. This allows you to appraise each investment opportunity on its own merit, while determining the best strategies for capitalising on macroeconomic trends in the stock and commodity exchanges. Above all else, comprehension and determinism makes it easier to identify relevant stock and commodity trends in relation to individual assets, laying the foundations for greater short and long-term profitability. 
 

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