One of the approaches we use for our signals is a classic trend-following model. It may sound obvious but the model works when the markets are trending. And yet so many traders attempt to trend trade when the markets really aren’t trending. Market type analysis and asset selection really are the most important part of a trading plan. Sometimes there simply aren’t trends in FX and that’s when you can explore other markets for quality trades.
The best trend in the past month has been in the Dow Jones. So today we’ll get acquainted with it a little better.
Global Equity Markets
If you’re waking up in Europe and turn on the financial news channel, the main stories will cover what has happened during the AsiaPacific session. But you won’t immediately hear commentary on FX. Instead, the commentary will veer firstly on what the Nikkei has done, whether the Shanghai Composite has followed suit, and what the bookmakers are expecting for the opening of the DAX and the FTSE.
If you’re waking up in the US, things will be similar: commentary will start with what the DAX and FTSE have done and what the main influences for the moves have been.
The stock market is a series of exchanges where the trading of equities (i.e. companies’ stocks) takes place. Indexes are used to measure changes in the stock market as a whole and 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. – also called “blue chips“.
The indexes that measure the value of blue chips (which usually have an international reach and are not just connected to the domestic economy) are widely followed and represent a gauge of the current state of the economy. The indexes are a “financial barometer” so to speak.
Why Should I Follow the Dow?
All traders have a favorite market. But if you just stick to one market you will miss out on some of the best trends around. Here are some empirical observations that can help you connect movements in FX to movements in the Dow and other asset classes:
- If the Dow rises, it can be for various reasons. Since it’s priced in USD, it may mean that USD is declining. Since the Dow is also a proxy for global risk sentiment, when it’s rising, it can also pull Jpy crosses with it. At the same time, the Vix will be declining.
- When the domestic currency rises, the stocks of exporting businesses like Exxon Mobil in the chart below 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).
- When Gold rises, the USD usually falls, AUD and Cad usually rise.
Dow Jones Fundamentals
When thinking about stock market fundamentals, one thing trumps all else: growth. Earnings are the cornerstone of stock analysis and the Dow is no different. Companies produce and sell their goods & services and thus the future potential growth of the economy needs to be taken into consideration. If the economy is generally buoyant, companies will sell their products and the forecast for future earnings will be good. Vice-versa: an economic downturn implies lower consumption and thus lower earnings estimates.
Mathematically, we can divide all stock price changes into just two categories:
- changes in multiple(s). This means that stock traders change their view of what a stock is worth without any underlying change in the stocks’ achieved revenues or earnings. For example the (trailing) P/E ratio or multiple changes, or the Price to Book value ratio changes. Externalities (broader market considerations) and short-term trading are the cause of this. Multiple changes are responsible for almost all of the day-to-day, minute-to minute, movement in stock prices.
- changes in fundamentals. For example when it releases the financial performance for the latest quarter. Fundamental growth is responsible for most of the long term change in a stock’s price over a period of years.
At the end of each month, FX traders are always interested to figure out where the largest month-end flows will be. Month-end flows are mostly dictated by index managers because they start with an allocation at the beginning of the month, with certain weights on YM, DAX, FTSE, Nikkei for example. The manager will need to rebalance at month’s end based on the performance of the basket. If, as is happening right now, the Dow closes the month with tremendous gains while the other indices are more or less flat, then the portfolio will be overweight USD compared to the other currency exposures. So the manager will need to sell USD (i.e. rebalance his Dow position) during the fixings of the last day (or last couple of days ) of the month.
Over to You
Hunting quality trends should be the main preoccupation for trend-followers. US indices and the Dow in particular, have been possibly the best trend to be on, in the past month. And it still is not showing any sign of stalling. The message should be clear: diversify but don’t diworsify! Look for quality trends amongst various markets so that when your preferred vehicle is sitting still with the 4-way flickers on, you might have other opportunities to take advantage of.
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.