Lessons from the Pros

Money for Leads?

As many of you know, I choose to trade more than just equities for several reasons. One reason is because I spot opportunities in these other assets as I am analyzing them for my stock trading. Previously, I have written about using commodities as a leading indicator for the stock market. In my last article, Mining for Leads, I wrote about using leading ETF’s or markets to track the possible future movement of another. All markets world-wide are related. Changes in price and direction in one tradable security will generally affect others. Most stock traders believe this refers to related stocks or sectors only. However, in looking at trading from a broad economic viewpoint, we see the ripple effect of all markets and can increase our chances for success. Today, I would like to discuss the use of a currency to anticipate the possible movement of the US Equity market.

Investors buy stocks in anticipation of increased profits for the underlying company. They also expect an increase in the economic output of the overall country as a result of bullish activity from the companies. Prosperous economies lead to higher demand by its citizens. Higher demand will lead to increasing prices we know as inflation. A side effect of an expanding economy is an increased need for raw materials for production and the feeding of the industrial machine. Countries that produce these commodities will prosper during this time. Enter the Australian Dollar. Australia is a major producer of gold, copper, and other materials that are required by growing economies. In fact, the Australian Dollar has approximately a 75% positive correlation with the S&P 500! When the market rises, so does the Aussie.

Compare that with the Japanese Yen, long considered to be a "safety currency." I know that typically we refer to the US Dollar as a safe haven currency, but the Yen has a 65% Negative correlation with the S&P 500 and that is usually much higher than the US Dollar’s relationship.

Let’s compare the currency pair of AUD/JPY (Australian Dollar vs Japanese Yen). Notice how the currency pair in the red tends to lead the S&P 500 in the blue at major turning points. Even the reversal of the bearish market in March 2009 was predicted by a sudden turn to the upside of the AUD/JPY in February of that same year.

Figure 1

In fact, the entire market collapse was predicted by prior movement in the currencies before it was experienced in the equity indexes. The next chart shows a weekly chart of the AUD/JPY on top, and the S&P 500 index on bottom. In mid 2007, the Aussie/Yen failed to break to new highs and held resistance. This warned of potential weakness in the S&P 500. I already commented on the end of the market’s drop being predicted by the currency, but you can see it here with a double bottom in late 2008, early 2009. Even the most recent market declines were visible ahead of time with a break of support in the Aussie/Yen pair.

Figure 2

If we look at the daily chart comparing the two securities, the AUD/JPY will often hit support or resistance before the equity market and cause or signal a reversal. This even occurs in December 2009 when the currency breaks out of a downtrend and takes the S&P out of a channel to continue the upward march in price.

Figure 3

Fortunately, currency data is free with all data providers so it doesn’t hurt you to look at an indicator to help you with gauging the markets. Until next time, trade safe!

Have a great day.

- Brandon Wendell bwendell@tradingacademy.com