The Multi-Market Analyzer next computes the proprietary Stretch Index, the Unstretched Indicator and the Market Leadership Index to give us a sense of the current market situation.
The Stretch Index (DSI) is an economic indicator that is designed to help identify a non-harmonious market mix and market opportunities that are a part of a larger correlated subset. The basic original premise for the original development of MMA was to identify economic and statistical opportunities for investment and the DSI represents one of many tools for satisfying that requirement. The stock and commodity markets represent an imperfect environment for analytical opportunity because all of the forces that bear upon the markets cannot be completely identified. It is true that many of the external forces that drive our economy are present through market price data and governmental input, but factors such as weather, marketing, supply and demand, war, international commerce and many others are not readily available and quantifiable. Fortunately, however thanks to the wide scope of Unfair Advantage's (UA's) database reserves, many of the related markets and symptoms can be found in UA's data resources.
If all of the pertinent economic factors were available for review including those unpublished elements listed above, then any trade one might wish to enter through the markets would be strictly a gamble that would have as its purpose an attempt to predict the future more perfectly than what would be possible by any analyst. The elements of MMA are designed to get the most out of the data that is actually available through mathematical means and suggest opportunities where markets are violating the statistical properties of equilibrium. The DSI can identify from a historical learning perspective where markets should be priced if they followed historical norms. It can answer the question, for example, "Are live cattle prices high or low with respect to live hogs, corn, wheat, oats, and crude oil?" Notice that products which are related to the development of cattle are included in our example. Hogs are a substitute for cattle, and wheat, oats and corn are substitute feeds, and crude oil will power the farm equipment. MMA's correlation matrix and factor analysis already introduced, would be used to help identify the opportunities for exploring market harmony.
The DSI is a standard deviation or variance calculation designed to measure market harmony. A reading should generally lie in the range of plus to minus 3 sigma. Markets which exhibit an overall reading at the extremes are exhibiting non-harmonious behavior, whereas a reading close to zero suggests that the markets are behaving as they have in the past and are considered harmonious and within the bounds of equilibrium. Opportunities for profit are generally confined to the higher sigma readings. One should exercise caution when considering a reading much above 3 sigma because this could suggest a change in behavior not encountered in the past and may very well represent a new development that could discredit traditional norms. In the above example shown above, the overall DSI is shown at 2.758 which is in the realm of non-equilibrium and indicates that an opportunity may readily exist.
The Unstretched Index (DUI) tells you, for each market, where its price would have to go if all of the other prices remain at their current levels. Suppose you were analyzing corn, soybeans, and live cattle. If the corn prices are very high and the live cattle prices are very high, the "Unstretched" price for soybeans will be very high as it tries to accommodate both the corn price and the live cattle price without regard to its own economics. The Unstretched Indicator measures how far each market would separately have to move to absorb all of the underlying market forces itself. It predicts the price of each market based solely upon the movement of the other markets.
This set of indicators for all markets should explain which markets led to the misalignment suggested by the Stretch Index. Don't be too surprised if the Unstretched Indicator is several large points away from the current price for some markets. The markets, as a whole, will tend towards equilibrium, with each market doing some of the accommodating. The problem for the trader is to predict which market or markets will do the moving. In the real world, it is unlikely that any one of these markets will make up all the price difference to return the relationships to the norm. More commonly, each market moves a little toward the center until equilibrium returns.
If, however, the spread between Unstretched Indicator and the actual price widened or closed abruptly at an abnormal peak in the Stretch Index, then perhaps the market factors didn't just stretch, but they snapped. That is, the underlying economics changed. In this event, try reducing your date range to exclude this event and see if the spread between the Unstretched Indicator and the actual price is more consistent. A word of warning: These indicators work best with a fair number of markets. At least three must be specified and more are preferred.
A spread trader might look for the pair of commodities with the biggest total discrepancy between the Unstretched Indicator and the current price level. Confirm a spread opportunity by consulting the correlation table to determine how closely the two market opportunities are correlated. If the correlation table shows a high or very high reading of, say 0.70 or higher, then this may represent an excellent opportunity for speculative profit.
In our example, corn is overpriced relative to its Unstretched Indicator. Wheat and soybeans are underpriced, indicating potential spreads of long W or S against short C. Live cattle are overpriced and lean hogs underpriced, indicating potential for a short LC / long LH spread. Coffee is overpriced and cocoa is underpriced, indicating potential for a short KC / long CC spread.
Elasticity Index The Elasticity Index is not currently implemented; please ignore it.
Market Leadership Index
The Market Leadership Index is the piece that completes the puzzle. The Stretch Index tells us that some markets are going to move. The Unstretched Indicator tells us what would happen to a market's price if it followed the other markets. But not every market follows, some lead.
The Market Leadership Index measures in bars the recent historical tendency for the Unstretched Indicator to lead or follow the market. That is, if the input markets were weekly series, the index will be in units of weeks. Large positive values mean that in recent past, the market tended to get ahead of the market changes. A negative value means that the market recently has been slow to accommodate economic changes. A value near zero means that the market, in recent history, has promptly fully discounted all factors.
Press "Next" to view a graphical screen with the historical plot of the indicators.