Why Everyone Must Monitor A Stock Index Chart

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 |  Includes: CORN, EURX, QQQ, SPY, UUP
by: Cliff Wachtel

Using Stock Indexes As Market Barometers: How To Know Within Seconds Where Most Currency Pairs, Or Other Assets, Are Going. The First Step To Understanding What's Moving Markets.

Part 3 Of Our Series On Inter-Market Analysis

What if you could get a good idea of how all forex pairs or other major markets are trending, in just a matter of seconds, by looking at just one chart?

You would be a much better trader or investor.

  • If normal correlations between that chart and other assets were working, you'd have a much better feel for market direction, and over time you'd learn how different kinds of developments influence different markets.
  • If you saw assets diverging from their normal correlation, suddenly moving in unexpected directions, then you'd quickly know to start investigating whether the change was meaningful or just random noise.
  • You'd develop a better sense of what are the underlying forces driving that chart.

In fact you often can do this.

As we'll explain below, you just need to find which major stock index most reliably represents overall market risk sentiment. The answer can and will vary depending on such factors as:

  • Your usual trading session: Are you active, or at least making decisions and planning entries and exits, during the Asian, European, or US session, or during hours when two regions are open?
  • Your anticipated holding period: As we'll see, traders with very short holding periods will usually need different indexes than long term investors.

As discussed in our introduction to inter-market analysis, most asset classes are risk or safe haven assets, that is, they tend to trend up or down depending on whether markets are feeling optimistic or pessimistic. Thus they are to varying degrees influenced by overall prevailing risk sentiment, aka risk appetite or risk aversion.

Therefore in order to better predict and confirm the state of their positions and portfolios, every active trader or investor needs a way to monitor risk sentiment for the time frame in which they trade and their anticipated holding period.

This article will focus on why certain leading stock indexes make good "quick and dirty" risk sentiment barometers, and which ones to follow depending on your time frame and trading session. The focus is on forex markets and traders, but most of what's written here will be relevant to those involved in other markets.

Currencies Not Ideal Risk Barometers

As we discussed in Part 2 of this series, the major currencies and currency pairs can be classified as risk or safe haven assets and are sensitive to risk sentiment.

Here's that handy table that shows the how the major currencies rank on the risk spectrum.

Why Everyone Must Monitor A Stock Index Chart Part A

Why Everyone Must Monitor A Stock Index Chart Part A

Source: The Sensible Guide To Forex: Safer, Smarter Ways to Survive and Prosper from the Start, Cliff Wachtel, John Wiley & Sons, 2012 01 oct 071653

See the above referenced articles for why understanding this table, and its ramifications, can be so useful for everything from market analysis to hedging your portfolio.

However, while currencies and currency pairs may be risk sensitive, they are not ideal overall market risk barometers compared to stock indexes.

  • Too many charts to track: Seven major pairs in addition to any other pair relevant to your trading style, easy to confuse risk and safety trends when under pressure.
  • Each pair subject to currency specific news

Allow me to elaborate.

Harder To Monitor Many Charts At Once

Big stock indexes are comprised of multinational and so are diversified into most sectors and regions. Currency pairs are more influenced by their specific underlying economies. So depending on your situation, you may need to monitor a wide range of currency pairs. Currency ETFs or indexes can be flawed measures of risk and the currency because of the way they're constructed. The need to monitor multiple charts exacerbates the following complications. For example:

  • Need To Filter Out Local Developments For Each Currency Pair You're Watching: For example, it's hard to monitor 8 different major pair charts and filter out effects of local developments on some of them at the same time.

Currency specific news can override the effects of risk sentiment. For example even when markets are feeling good and risk assets are rallying, the AUD or NZD may fall if there is bad news out about their economies or about the economies of their major trade partner, China.

  • Easier To Confuse Which Pairs Move With Or Opposite Risk Appetite: Moreover, currency pairs move up or down with the currency on the left, called the base currency (think: price movements are 'based' on the currency on the left).

For example, if the EURUSD is moving higher that means the EUR is appreciating versus the USD, because EUR (on the left) is the more of a risk asset, the USD is more of a safety asset. Thus a rising EURUSD suggests rising risk appetite (optimism). However in other pairs the base currency is the more safe-haven of the two and so the pair moves in the opposite direction of risk appetite. For example the USD is lower on the risk spectrum than the CAD, so if the USDCAD is rising that suggests risk aversion.

If you're under pressure it's easy to get confused about what a given pair's trend is telling you, especially if you're looking at many charts at once.

Major Stock Indexes A Simpler, More Comprehensive Risk Barometer

You can get a good fix on prevailing market sentiment while avoiding the above issues by just monitoring one, maybe 2 (if you're active when different continental market hours overlap) stock indexes.

The scope of activities of their component companies encompasses virtually all sectors and regions of the global economy, so if you pick any of the largest indexes in a given region (Asia, Europe, US), you should have a good quick read of risk sentiment at a given moment.

Which stock index or indexes serve as your sentiment barometer will depend on your

  • Planned holding period
  • Chart time frame
  • Asset class

Best Risk Barometer Indexes In General

First we'll deal with indexes as general risk barometers, then look at how they work for forex traders.

Over The Long Term, Most Indexes Major Stock Indexes Trend Together: For example, as shown in the charts below, over the longer term the major indexes trend together. We define a long term holding period here as 6-12 months or longer, as distinguished from multi-year holding periods, which we'd call "very long term". Feel free to disagree with the precise holding period definitions, the key here is that you know how we've defined our time frames here.

ScreenHunter_02 Oct. 01 17.36

SAMPLE OF MAJOR GLOBAL STOCK INDEXES, WEEKLY CHARTS MID JULY 2012 - OCTOBER 1 2013: LEFT COLUMN TOP TO BOTTOM: S&P 500, FTSE 100, DAX 30, MIDDLE: CAC 40, DJ EUR50, MSCI TAIWAN, RIGHT COLUMN: HSI, CHINA A50, NIKKEI 225

Source: MetaQuotes Software Corp, www.fxempire.com 02 OCT 011736

Therefore as a general rule, long term investors can use any of the largest global indexes to gauge long term risk appetite. There are some variations from this rule that we'll discuss below.

In the short term indexes correlate better by region or trading session: In the short term, as shown in the four hour charts below, indexes correlate better by region. We define short term here as a month or less. Again, feel free to disagree over this definition, the important thing here is that you understand our time frames here. We leave very short term and intraday trading time frames for a separate article.

ScreenHunter_05 Oct. 01 19.22

SAMPLE OF MAJOR GLOBAL STOCK INDEXES, FOUR HOUR CHARTS, FROM MID TO LATE SEPTEMBER 2013: LEFT COLUMN TOP TO BOTTOM: S&P 500, DOW JONES INDUSTRIAL AVERAGE (AKA DOW JONES 30), FTSE 100 MIDDLE: DAX 30,CAC 40, DJ EUR50, RIGHT COLUMN: MSCI TAIWAN, HSI, CHINA A50, NIKKEI 225

SOURCE: Source: MetaQuotes Software Corp, www.fxempire.com, thesensibleguidetoforex.com 05 OCT 01 1922

Note how, on these 4 hour charts, the trends vary by region (although the Nikkei more closely resembled the European indexes in this case), whereas on the weekly charts the there was little difference US, European, Japanese, or Australian stock index trends on the weekly charts above.

The key takeaway point here is that your holding period, and thus your chart time frame, influences your choice of which stock index to use as a risk barometer.

  • If you're a long term investor with typically long (multi-month or year) holding periods, you can afford to stick to the very biggest global indexes like the S&P 500, because as shown below, their trends are similar over time. Their components (or similarly large capitalization indexes) cover virtually every business sector and region and so provide a good overview of risk appetite. More on this below.
  • Shorter term traders, especially those with holding periods of less than 48 hours, will find it best to stick to a large index that's active when they trade, as index trends vary from region to region in the short term. So if you only trade in during one of the three global sessions (Asian, European, or Americas) you can usually suffice with following just the largest index that's actively traded during your session. More on that below, too.

The Best Risk Barometer Indexes For Forex Traders

We looked at a lot of different combinations of index and currency charts in a variety of time frames. A full review would get tedious, so we'll just hit the highlights for now.

Best Indexes For Gauging Short Term Risk Sentiment For Forex

The short version: short term forex traders will usually get a better read of relevant risk trends by using an index that's active during the session in which they're active, be it Asia (Nikkei, Hang Seng, All Ordinaries, MSCI Taiwan etc.), Europe (DAX, CAC, FTSE 100 etc.), or US (S&P 500, DJIA, etc.). If you're active during the highest volume hours of the trading day, when both London and New York are trading, you'll have to experiment with which index or combination from New York, London, or Europe gives you the most relevant risk sentiment read for your personal mix of assets and time frame.

For example, the below set of four hour charts compares a stock index, the S&P 500, with a few forex pairs with components from the opposite ends of the risk spectrum, so that we'd expect them to be especially sensitive to risk sentiment, which would send each half of the pair trending in the opposite direction.

ScreenHunter_03 Oct. 01 18.09

SAMPLE OF RISK-SENSITIVE MAJOR FX PAIRS FOUR HOUR CHARTS VS S&P 500 @ 11:09 EST OCTOBER 1 2013: CLOCKWISE S&P 500, AUDJPY, NZDCHF, AUDUSD, WITH 10 PERIOD EMA (RED), SEPTEMBER 9 - OCTOBER 1, 2013

SOURCE: Source: MetaQuotes Software Corp, fxempire.com, thesensibleguidetoforex.com 03 OCT 011809

As you can see, these representative risk pairs indeed moved in the same overall direction as risk sentiment, at least as portrayed by the S&P 500, suggesting that these pairs indeed were moving with risk sentiment as shown by that index.

A few caveats are of course in order.

  • Risk Sentiment Can Be Overridden: While forex pairs are heavily influenced by risk appetite, and that the right stock index will do a good job of representing that overall sentiment in given time frame, risk sentiment is just one of a number of forex trend drivers, it can be overridden by other market drivers. Also, a given index may not always accurately reflect how that sentiment is influencing a given pair.
  • Fundamentals Matter Less In The Very Short Term: For those holding for a matter of minutes or hours, the relevant short term currency trends can be uniquely influenced by short term money flows. For example:
    • If a big multinational transaction is being closed, that can cause a short term spike up or down in the related currencies if one of the parties decides to convert a large block of currency.
    • Or if Japanese companies are given a temporary tax break on repatriated profits earned abroad, the normally safe-haven JPY could spike higher even during a period when its fellow safe-haven currencies are falling and risk currencies are moving up.

Therefore day these are less important to intraday traders who are in and out of positions within a matter of hours.

In other words, over the course of weeks these amounts are not material compared to the roughly $5.3 trillion traded daily on forex exchanges. However they can be influential on a very short term basis, especially when unusual activity can set off a wave of computer-generated trades.

That said, from the set of 4 hour charts we saw above (shown again here below), we can see that stock indexes in the same trading session or region show strong correlation. That boosts our confidence in them as short term risk sentiment barometers, as we'd expect them to be influenced by the same market drivers which in turn would shape risk sentiment.

Why Everyone Must Monitor A Stock Index Chart Part B

Why Everyone Must Monitor A Stock Index Chart Part B

SAMPLE OF MAJOR GLOBAL STOCK INDEXES, FOUR HOUR CHARTS, FROM MID TO LATE SEPTEMBER 2013: LEFT COLUMN TOP TO BOTTOM: S&P 500, DOW JONES INDUSTRIAL AVERAGE (AKA DOW JONES 30), FTSE 100 MIDDLE: DAX 30,CAC 40, DJ EUR50, RIGHT COLUMN: MSCI TAIWAN, HSI, CHINA A50, NIKKEI 225

SOURCE: Source: MetaQuotes Software Corp, fxempire.com, thesensibleguidetoforex.com 05 OCT 01 1922

In other words, note how the US indexes on the left basically move together, as do the European indexes in the center column, as well as the Chinese indexes in the top and middle of the right column. The Nikkei, on the bottom right, more resembles the European indexes. That's interesting because, as we discuss below, over the longer term the Nikkei's overall trend for over the past year has more resembled those of the US and Europe than Chinese and other Asian indexes. We can speculate about reasons, but that would be beyond the scope and focus of this article.

In sum, the evidence we've seen suggests that for shorter term (assuming you believe four hour charts are for shorter term trading), the chart of a stock index that is active when you're trading can be a useful risk appetite barometer.

Best Stock Indexes For Gauging Long Term Risk Sentiment For Forex: None

Short version: While stock indexes are good risk sentiment indicators, we didn't find any that were really useful for tracking forex trends over the long term. We could speculate on any number of reasons (central bank interventions distorting normal correlations, other factors overwhelming risk sentiment, etc.) but that would be well beyond the intended length and scope of this article.

Here are the details for those interested (if not feel free to skip to the next section).

First let's look at how risk appetite as portrayed by the indexes looks on a longer term perspective by again viewing the weekly charts for these indexes.

ScreenHunter_02 Oct. 01 17.36

SAMPLE OF MAJOR GLOBAL STOCK INDEXES, WEEKLY CHARTS MID JULY 2012 - OCTOBER 1 2013: LEFT COLUMN TOP TO BOTTOM: S&P 500, FTSE 100, DAX 30, MIDDLE: CAC 40, DJ EUR50, MSCI TAIWAN, RIGHT COLUMN: HSI, CHINA A50, NIKKEI 225

SOURCE: Source: MetaQuotes Software Corp, fxempire.com, thesensibleguidetoforex.com

02 OCT 011736

Not surprisingly, regional differences among major stock indexes matter less over the course of months than they do over a matter of days or weeks. The major market movers exert a broader influence over a longer period and drown out minor and short term local factors. The bigger, more lasting economic trends have time to exert themselves.

The US, European, Japanese and Australian (not shown) indexes have been strongly correlated and have similar overall trends, albeit with some variations in timing. In other words, correlations in risk appetite as portrayed by these indexes go beyond regions or trading sessions and are shared by US, European, and some Asian markets.

However Taiwan, Hong Kong, Korea (the Kospi - not shown) and Straits Times (Singapore - not shown) indexes have all been in a flat trading range for 2013 the same period.

Again there we'll avoid speculating on the reasons for the differences, and just note the difference in risk appetite as portrayed by the different regional indexes.

The key point here is that while longer term investors or traders (those holding positions over this period shown above could theoretically use any of the US, European indexes for an overall picture of risk sentiment trends, - NONE WOULD HAVE HELPED MUCH TO PREDICT OR CONFIRM FOREX TRENDS over that period of Mid-July 2012 to October 2013.

The set of weekly charts below compares the S&P 500 with the same set of risk sensitive pairs we used above to discuss short term risk correlations between stock indexes and forex pairs. Note how the weekly trends of the forex pairs either don't correlate very well (in the case of the AUDJPY) with that of the S&P 500 or diverge (the others) for well over the past year.

ScreenHunter_03 Oct. 01 18.09

SAMPLE OF RISK-SENSITIVE MAJOR FX PAIRS WEEKLY CHARTS VS S&P 500: CLOCKWISE S&P 500, AUDJPY, NZDCHF, AUDUSD, WITH 10 PERIOD EMA (RED), NOVEMBER 2011 - OCTOBER 1, 2013,

ALL ARE PAIRS WITH COMPONENTS ON OPPOSITE ENDSOF THE RISK SPECTRUM

SOURCE: Source: MetaQuotes Software Corp, fxempire.com, thesensibleguidetoforex.com

04 oct 011850

Other major pairs didn't correlate any better over this period.

Remember, we just established that the S&P 500 is a good representative of long term stock index trends and thus of overall risk appetite. We could have used any of the other US or European indexes shown above, perhaps those for Taiwan and Japan too, and gotten the same basic upward trend that suggested a period of risk appetite.

It wouldn't have mattered. None would have been useful for predicting or confirming these currency pair movements over a similar period.

Fortunately there are other barometers of risk appetite that may correlate better with your particular mix of trading session, portfolio, time frame and holding period. We'll cover these in coming articles.

Conclusions

The above is far from an exhaustive study, so we look forward to comments from readers. That said, here's what we've found.

General Conclusions

Most major stock indexes trend together over the long term. So if your anticipated holding periods of about a year or more, any of the indexes would do as an overall risk barometer. Therefore your ultimate choice of index would depend on which best matches your own investing or trading focus. For example, those more focused on smaller cap US stocks might prefer the Russell 2000. Those focused on technology might prefer the Nasdaq, and so on.

Over the shorter term the trends of the big global indexes vary with regional trading sessions. Therefore traders with anticipated holding periods of less than a few days need to stick to the regional index that best correlates with their preferred trading instruments. For example, Asian commodity traders might want to consider monitoring an index of an Asian commodity producer of the commodities they trade.

Conclusions For Forex Traders

For those with holding periods of a few days or weeks, as shown in the four hour charts, a major stock index will help predict and confirm risk sentiment as its influencing currency pairs. Longer term weekly charts were not especially helpful in predicting currency pair movement.

Focus On The Underlying Drivers Of Risk Sentiment And Forex Trends

Remember that not only is risk sentiment just one of a number of key global market drivers, it is typically just a reflection of the combined effect and interplay of the real underlying trend drivers, such as actual and anticipated trends in interest rates, growth, employment, spending, economic policy, geopolitics etc.

For example, as we discussed here in Part 2, arguably the key global market driver in the recent years of the Great Financial Crisis has been central bank policy and interventions.

Unfortunately, it can take a lot of time and effort to follow Asian, European, and US markets each day and discern what's been driving them.

New To FXEmpire.com: Your Shortcut To Knowing The Leading Market Drivers And Their Ramifications

Fortunately, there's an easier way.

Just follow me. New to fxempire.com, I'll be providing updates on what are prime forces moving most or all of the major global asset markets. Sometimes the updates will come daily, sometimes weekly. It all depends on what's happening in the markets.

Want To Know More?

Inter-market analysis is a huge topic, so this series is just to provide an overview so that you're better able to pursue more in-depth study on your own. See here, and here for the rest of the articles .

For more in-depth coverage of this topic, and all topics covered in this series on inter-market analysis, see The Sensible Guide To Forex: Safer, Smarter Ways to Survive and Prosper from the Start (Wiley 2012).

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.