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Market Correlations & Constructive Interference

In trading it helps to have a basic understanding of how markets play follow the leader, and how you can use this information to improve your trade selection. Markets work best when asset class vehicles are being actively purchased for investment and savings by the world's working population. Asset class purchases by global workers and their companies provide the cash stream that fuels the global financial markets. There is also the other side of the coin, consumption. How much are individuals and companies consuming, before savings and investing needs can be met? Business and investment flows sometimes slow down, and sometimes pick up. It is simple to see who the "leaders" are in financial markets in both up and down markets, by seeing which market are up (or down) by the largest percentage on a closing basis from the day, and/or week before, and from the size of their recent retracements. The more shallow the retracements the stronger the market, and the steeper the slope. Currently the financial markets have a tight correlation to the U.S. stock market, which is the current alpha market. The EURUSD, the world's most heavily traded financial instrument's price movement correlated to nearly 80% of the S&P 500 earlier in the year, with the Aussie showing a similar attachment, and crude oil correlated at nearly 90% of the S&P 500. What this meant to currency and commodity traders is they had better not be long Aussie, or crude oil, if the U.S. stock market is moving lower, or vice versa. The correlations also lend us both a measuring stick, and a timing mechanism based on deduction to assist in our trading. Once market volume slows down however, and markets find themselves in slower counter-trending markets, such as the dog days of July and August, the correlations break down, which means shorter, more truncated price moves.

In trading it helps to have a rudimentary understanding of constructive interference, or harmonic resonance. This can be demonstrated by dropping two pebbles into the water at the same time. The waves from each pebble synchronize because they hit the water at the same time, and combine to create larger waves, which spread out in a wide circle. In science this is called constructive, or positive interference. Destructive, or negative interference, on the other hand, occurs when two pebbles are dropped out of synch, and one hits the water a split second before the second, and the waves from the first offset the waves from the second and the water is quickly smooth again. Market correlations work the same way. We see the biggest moves occur when all the markets - all the different asset classes: stocks, carry, and cash are moving together in the same direction and approximate speed -- volatility. When they are not, and AUDUSD is moving higher and EURUSD is moving lower for example this is negative interference - see Figure 1.

Figure 1.

As directional, discretionary traders we need to learn to take trade signals when markets are moving toward greater constructive interference, so to expect sustained price movement, and avoid trading during times of destructive interference when markets are out of sync and push and pull against each other in sloppy directionless ranges such as the EURUSD in the right panel of Figure 1, or in the dog days of summer, or late December.

Figure 2.

Figure 2 on the other hand depicts an example of the type of increasing, or positive interference we look for which is a harbinger of larger market moves to come. While the Aussie on the left and the Euro on the right are initially in negative interference w/ the Aussie in a bearish pattern and the Euro in a bullish pattern, the buy signal circled in the Aussie on the left signals that both markets are now in confluence -- moving higher together, and a substantial rally follows in the Euro, which had the benefit of already having been in an uptrend. Knowing which the laggard is, and which is the leader, and taking buy signals in the strong markets, and short signals in the weaker markets follows a crucial tenet of trading: buy strength, and sell weakness.

Please keep in mind that when we say asset class markets we are referring to only investments that provide a dividend or yield. While many economist consider commodities, such as crude oil, to be an asset class, and commodities are currently highly correlated to blue-chip stock prices, commodities do not offer a dividend or yield, and in fact can incur a cost of carry - cost of storage and safe-keeping. It also is not a good idea to expect thinly traded markets to have the same tight correlations and interference readings that the most heavily traded markets do.

Jay Norris is the author of The Secret to Trading: Risk Tolerance Threshold Theory. To see Jay highlight trade set-ups and signal in live markets go to Live Market Analysis

Trading is a risk endeavor and not suitable for all investors

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.