Order Flow Boot Camp

Why the Stock Index is Important

Trading in a global world

When an earthquake in Japan can influence international equities, the FX and bond markets, it becomes important to know how the various asset classes tie together. Whilst this subject will be explained more in-depth in Trading 202, here we shall start to lay down the groundwork for intermarket analysis between stock indexes and the foreign exchange market.

1. Global Equities

Turn on any financial media news station, website or social media feed and one of the first things that will be spoken about or shown is the situation of global equities. If you're waking up in Europe, the main stories will cover what has happened in Asian bourses: what the Nikkei has done, whether the Shanghai Composite has followed or led, and what the bookmakers are expecting for the opening of the DAX and the FTSE. Going through the day, the US markets start to wake up and they go through the same drill taking their cue from Europe: what have the DAX and FTSE done and what are the drivers being carried stateside.

The stock market is a series of exchanges where the trading of equities (i.e. companies' stocks) takes place. So if you recall the lesson on the Fundamentals of the Dow, you'll recall how the main focus is on earning and the companies' profitability - which in turn needs a good economic environment that keeps consumers active. Indexes are used to measure changes in the stock market. There are many different indexes and each represents a pool of stocks. The Dow Jones Industrial Average (DJIA) is perhaps the one most commonly reported by news media. The Dow is comprised of the 30 largest stocks in the U.S. and the daily Dow shows how these stocks perform on a given day. The Dow average is a price-weighted average meaning it is based on the price of the stocks.

The S&P 500 is comprised of the 500 largest capitalization stocks traded in the U.S. These two indexes are generally accepted representatives of the overall economy in the U.S. and are the most followed measurements of the U.S. stock market. The indexes that measure the value of these stocks are widely followed and are a critical data source that Main Street looks to to gauge the current state of the economy. The indexes are a "financial barometer" and the stock market has become an influential part of the financial decision making process.

2. The most important indexes

Dow Jones Industrial Average (the Dow): one of the premier stock indexes in the U.S. It measures how well the top 30 publicly owned companies are trading. Despite the name, barely any of the companies have anything to do with industrial production and are instead representative of some of the biggest companies in America. It is the second oldest U.S. market index after the Dow Jones Transportation Average, which was also created by Dow. It is closely watched by investors around the world and is highly indicative of market sentiment, thus making it sensitive to both local and foreign economic and political events because the companies that are part of the Dow operate on an international scale.

S&P500 (the S&P): The Standard & Poor 500, more commonly known as the S&P 500, is a weighted index of the stock prices of the 500 largest American companies. It is considered a tell-tail for the American economy and is used to predict its direction. After the Dow Jones Industrial Average, it is the most highly traded index in the U.S. and many funds are explicitly designed to track the performance of the S&P 500 index. It is widely used as a measure of the general level of stock prices, as it includes both growth stocks and value stocks.

Nikkei225 (the Nikkei): The Nikkei, similar to the Dow Jones Industrial Average, is the most widely quoted average of the Japanese stock market. It is a price-weighted average of the top 225 companies and is supposed to be reflective of the overall market. The Nikkei includes companies like Toyota, Bridgestone, Japan Airlines, and Fuji film. The Nikkei average has deviated sharply from the textbook model of stock averages which grow at a steady exponential rate. The average hit its all-time high on December 29, 1989, during the peak of the Japanese asset price bubble, when it reached an intra-day high of 38,957.44 before closing at 38,915.87, having grown sixfold during the decade. Subsequently, it lost nearly all these gains, closing at 7,054.98 on March 10, 2009 - 81.9% below its peak twenty years earlier.

DAX: The DAX is short for the Deutscher Aktien Index. It is the stock market index in Germany that consists of the top 30 blue chip companies that are traded on the Frankfurt Stock Exchange. With Germany being the largest economy in the euro zone, the DAX is normally the most closely watched index within the whole euro zone. Some companies that are part of the DAX are Adidas, Volkswagen, Deutsche Bank, SAP. It is the equivalent of the FT 30 and the Dow Jones Industrial Average, and because of its small selection it does not necessarily represent the vitality of the economy as whole. The Eurostoxx 50 is used sometimes as an alternative measure of broad European equities' performance.

FTSE 100: The FTSE (pronounced "footsie") index tracks the performance of the most highly capitalized UK companies listed on the London Stock Exchange. There are several versions of this index, such as the FTSE 100 or FTSE 250, depending on the number of companies included in the index. FTSE 100 companies represent about 81% of the entire market capitalization of the London Stock Exchange.

Hang Seng: The Hang Seng index is a stock market index in Hong Kong. By recording and monitoring the daily price changes of the stocks included in the index, it tracks the overall performance of the Hong Kong stock market. This index is currently compiled by the HSI Services Limited, which is a subsidiary of Hang Seng Bank.

Shanghai Composite: The Shanghai Stock Exchange (SSE) is a stock exchange that is based in the city of Shanghai, China. It is one of the two stock exchanges operating independently in the People's Republic of China, the other is the Shenzhen Stock Exchange. Shanghai Stock Exchange is the world's 6th largest stock market by market capitalization. Unlike the Hong Kong Stock Exchange, the Shanghai Stock Exchange is still not entirely open to foreign investors due to tight capital account controls exercised by the Chinese mainland authorities.

3. A note on Month-End Flows

One thing to remember is that in order to purchase stocks from a particular country, you must first have the local currency. A European Index manager that is long the Nikkei, for example, must first exchange his Euros (EUR) into Japanese yen (JPY). This increased demand for JPY causes the value of the JPY to appreciate. On the other hand, selling Euros increases Euro supply, which drives the Euro's value lower. When the outlook for a certain stock market is looking good, international money flows in. On the other hand, when the stock market is struggling, international investors take their money out and look for a better place to park their funds. So during any one calendar month, index investors will be looking closely at the performance of global indexes and will need to rebalance their portfolios at month end.

How does this happen and why is it important?

Comparison of 4 major global indices: Dow, Nikkei, Dax, FTSE

If an index manager starts an allocation at the beginning of the month, with equal weights on YM, DAX, FTSE, Nikkei, he will need to rebalance at month's end based on the performance of the basket. If, as is happening right now, the Dax closes the month with a -4% while the other indices are more or less -1% or -2%, then the portfolio of the manager will be basically twice as short Euros compared to Gbp (FTSE), Jpy (Nikkei), or Usd (YM). So the manager will need to buy Euros (i.e. Rebalance his DAX position) during the fixings of the last day (or last couple of days ) of the month.

By understanding this procedure, you can also connect the dots into FX space and be prepared to ride (or stand away from) these end of month flows. Of course the moves are not always tradeable, because you need a significant absolute performance of an index (rising or falling doesn't matter) in order to generate the necessity of a significant rebalancing.

If all else fails, then maybe it's just best to stand aside and let the month-end flows settle themselves out before re-engaging the markets.

4. Stocks vs. Forex link

Even though you may not trade stocks, as a forex trader, you should still pay attention to global equities. If the stock market in one country starts performing better than the stock market in another country, you should be aware that money will probably be moving from the country with the weaker stock market to the country with the stronger stock market. This could lead to strength in the currency of the country attracting capital and weakness in the currency of the worse performing market. The general idea is: strong domestic market, strong domestic currency currency and vice-versa.

Is there a direct correlation - is it that easy? Absolutely NOT. Actually there are other correlations that can be used as "rules of thumb" and are maybe more useful for practical applications. Just remember that correlations are not set in stone. Correlations can be seen as "trends between assets" and as such, the trends will change/evolve. How can we keep track of the changing correlations in a non-cumbersome way? You guessed it: Sentiment analysis. If you're really keen on getting your sentiment analysis straight, then go ahead and skip a few lessons. Go directly to the Mindset Lessons/Trading 202 and learn the tools to the trade.

So what are the intermarket "rules of thumb" that can be helpful to understand how capital flows have linked various asset classes? Here's the short-and-practical version:

  1. If YM rises, since it's priced in USD, the USD usually falls. Also, YM is a proxy for global risk sentiment so the VIX (risk index) should decline and the Jpy should also be sold. The YM/risk trade is one of the main reasons why currency pairs with the USD as a denominator are usually "cyclical" pairs: they usually rise when global equites rise and they fall when global equities fall. They follow the business cycle like global equities do. Hence the name "cyclical" currencies.

  2. It follows that when the Vix falls (rises) things are going well with the world and EurJpy, GbpJpy, AudJpy, NzdJpy and to a more limited extent EurUsd, AudUsd, NzdUsd, GbpUsd rise (fall) as risk gets bought (sold).

  3. When the domestic currency rises, the stocks of exporting businesses usually fall (because it's less convenient for their trade partners to buy from them) and the stocks of importing businesses usually rise (because it's cheaper for them to procure goods/services/materials).

  4. When Gold rises, the USD usually falls, AUD and Cad usually rise.

  5. When Crude Oil rises, usually the USD falls and CAD rises.

  6. When domestic bond yields rise, this usually attracts capital inflows (yield searchers) and hence drives the currency higher.

Bottom Line: global equity indexes are widely followed and are a critical data source that Main Street looks to to gauge the current state of the economy. The indexes are a "financial barometer" and are linked - via capital flows - to all other asset classes out there. It's important to know what the current market sentiment is, because correlations between asset classes change, strengthen, break down depending on what the drivers are in any given moment. But having a good pulse of global equities - even if you don't trade them - can help you understand the movements in FX, bonds and commodities as well.

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