Relationship Between Stocks and Forex
One issue with using global equity markets to make forex trading decisions is figuring out which leads which.
The basic theory is that, when a domestic equity market rises, confidence in that specific country grows as well, leading to an inflow of funds from foreign investors.
This tends to create a demand for the domestic currency, causing it to rally against other foreign currencies.
On the flip side, when a domestic equity market performs terribly, confidence falters, causing investors to convert their invested funds back into their own local currencies.
Sounds great in theory, but in reality, it’s…complicated.
For example, the historical relationship between the U.S. dollar and the S&P 500 hasn’t been consistent.
As shown below, over the last 20 years they have moved together, moved in opposite directions, and have been unrelated.
But that doesn’t mean the relationship is useless. You just have to know when the correlation is working (whether negative or positive) and when it’s not.
Here’s an example where U.S. and Japanese stocks moved in opposite directions of their currencies.
Any upbeat economic figures in the U.S. and Japan more often than not weigh down on their respective currencies, the dollar and yen.
First, let’s take a look at the correlation between the Dow Jones Industrial Average and the Nikkei to see how stock markets all over the globe perform relative to each other.
Since the turn of the century, the Dow Jones Industrial Average and the Nikkei 225, the Japanese stock index, have been moving together like lovers on Valentine’s Day, falling and rising at the same time.
Also notice that sometimes one index leads, rallying or dropping first before being followed by the other index.
It doesn’t happen every single time, but you could say that stock markets in the world generally move in the same direction.
When people talk about the stock market, you generally hear them using a stock market index in reference to the market’s performance.
A stock market index is simply a curated list of certain stocks. This list of stocks is a way to get a broad measure of what’s happening in the stock market.
In this lesson, we discuss how currencies can have an effect on two specific stock indexes:
The Nikkei 225 more commonly called the Nikkei, the Nikkei index, or the Nikkei Stock Average is a Japanese stock market index that measures the stock performance of Japan’s largest 225 companies listed on the Tokyo Stock Exchange (TSE).
The Dow Jones Industrial Average, Dow Jones, or simply the Dow, is a U.S. stock market index that measures the stock performance of 30 large American companies listed on the New York Stock Exchange (NYSE) and the NASDAQ.
Nikkei and USD/JPY
Before the global economic recession that started in 2007, when most economies suffered consecutive quarters of negative GDP growth, the Nikkei and the USD/JPY were inversely correlated.
Investors believed that the performance of the Japanese stock market reflected the status of the country, so a rally in the Nikkei led to a strengthening of the yen.
The opposite also held true. Whenever the Nikkei would drop, the USD/JPY would rise as well.
Correlation Between USD/JPY and Dow
Let’s take a look at the correlation between the USD/JPY and the Dow.
Generally, the strength or weakness of the dollar, impacts the U.S. stock market, particularly stocks of large multinational corporations (MNCs).
For large U.S. multinationals that sell goods and services overseas, a rising U.S. dollar can put a crimp into the profits.
If the dollar is strong, it makes a difference for those companies since it makes it difficult for them to increase prices or even maintain sales at current levels.
That said, you might assume that the USD/JPY and Dow would be highly correlated.
However, a look at the chart below would tell you that it isn’t quite the case. While the correlation is positive, it isn’t as strong.
Take a look at the Dow (blue line).
It peaked at 14,000 late in 2007 before dropping like a hot potato in 2008.
At the same time, USD/JPY (orange line) also fell, but not as sharply as the Dow.
This serves as a reminder that we should always take into account fundamentals, technicals, and market sentiment, so always read up!
Don’t take correlations for granted because they aren’t a sure-fire thing!