The stock and forex markets are two of the busiest and most liquid financial markets in the world, with both facilities seeing trading volumes of billions of dollars every day.
However, even though they are two distinct markets trading in two separate products — the former shares in private companies, the latter units of currency — neither exist in a vacuum and their performances are often intertwined.
As a result, investors who are primarily concerned with the forex arena can often still benefit from surveying the stock market’s behaviour when planning their trades — so let’s start with the basics: how do the two markets interact in principle?
What is the Theoretical Connection Between the Forex and Stock Markets?
Generally speaking, a strong domestic stock market lends support to that nation’s currency — for example, a surge in demand for US stocks invariably contributes to a strengthening of the US dollar, while a booming Japanese share market helps to drive up the value of the Japanese yen.
This is because as particular stocks from a given nation (or even region of a country) become more sought after, they inevitably pique the interest of foreign investors who begin seeking to acquire these shares for their own portfolio. In turn, this encourages demand for the nation’s currency, leading to an improving economic sentiment and the currency’s appreciation on the exchange market in relation to other competing currencies.
However, it’s worth noting that the opposite also tends to be true: a poorly performing stock market often has the knock-on effect of steering investors away from the country in question for the time being, thereby dragging the value of the currency — and its performance on the global trading arena — down with it!
Further reading: https://www.investopedia.com/articles/forex/11/how-equities-affect-fx-market.asp
How Does this Forex-Stocks Relationship Work in Practice?
On paper, the above correlative relationship sounds fairly iron clad, but in fact the true picture is much more complex. For instance, the movements of the USD and the US’ primary stock index, the S&P 500, have alternated through periods of close correlation and notable divergence over the past two decades.
A clear example of this occurred in the period following the millennium, when the so-called ‘dot com bubble’ — a phase of intensive growth in technology stocks throughout the late-1990s brought about by the rapid adoption of the internet in the developed world, which indirectly bolstered the dollar’s value — came to an end through widespread panic selling as the momentum that led to the overvaluing of these stocks became recognised as unsustainable.
During this initial readjustment period (the ‘bursting’ of the bubble), the US dollar unsurprisingly declined along with its domestic stock market — however, from around late 2002 to 2008, the US stock market experienced a resurgence whilst the USD continued to depreciate.
Similarly, between 2010 and 2015 the S&P 500 almost doubled in value thanks to a reinvigorated tech sector (spearheaded by the likes of Apple and Amazon) whereas the trade-rated value of the USD stayed fairly consistent — even though the 2010s was the first decade since the 1850s that the US didn’t experience a single recession!
Despite these discrepancies — alongside countless other examples — the basic correlation is still a useful rule of thumb to bear in mind, as long as you recognise there are always other factors at play that can override the status quo.
What are the Most Relevant Stock Indices for Forex Traders?
In order to gauge the performance of a particular stock market over time, most traders will pay attention to what are known as ‘stock indices’, which are frequently updated aggregates of the prices of a certain set of stocks over time.
Each specific index has a unique purpose and scope, ranging from global to national to regional in a geographic sense — with some including all stocks from the relevant region, others selecting only the most prominent and a number solely focusing on a particular industry or sector.
Some pertinent indices that are helpful for forex traders to monitor (as they serve as a bellwether for the overall economy) include:
- The Dow Jones Industrial Average (also known as the ‘DJIA’ or ‘Dow’ for short), perhaps the most well-known stock index to the general public, tracks the performance of the 30 largest companies on the US stock exchange and was first calculated in 1896. One of the oldest indices still in operation and a useful general measure of American economic prosperity and the USD’s value, some nevertheless argue that its comparatively small scope and lack of weighting (either by market capitalisation or arithmetic mean) render it less accurate and nuanced than the indices that followed.
- The S&P 500 is another popular US-focused index, this time tracking the top 500 companies on the US stock exchange. Unlike the Dow, the S&P is a capitalisation-weighted index, meaning that each company’s effect on the reading is proportionate to its shares’ market value, which is significant as its 10 largest companies account for over 25% of the index’s market capitalisation! Over the years, the S&P has effectively overtaken the Dow as the most relied upon USD-adjacent stock index due to its much wider selection and weighting mechanisms, and so even the most casual trader can benefit from following it as dramatic movements can far-reaching have ramifications across the wider forex market.
- The Financial Times Stock Exchange 100 (frequently abbreviated to ‘FTSE 100’ or colloquially the ‘Footsie’) is a UK-centric index that charts the performance of the top 100 companies on the London Stock Exchange by market capitalisation. A salient barometer of the British economy and by extension the GBP, the FTSE is weighted by free-float capitalisation and effectively gauges the health of companies regulated by UK company law.
- The DAX (short for ‘Deutscher Aktienindex’, literally ‘German stock index’) is a capitalisation-weighted index focused on the top 30 companies on Germany’s Frankfurt Stock Exchange. Because of Germany’s prominence within the Eurozone, it is sometimes used as an indirect measure of the EU’s performance as a whole and is therefore of use for EUR traders, although like the Dow its small selection means that it does not always accurately represent the vitality of the entire economy.
- The Nikkei 225 (or ‘Nikkei Average’) tracks the performance of 225 large Japanese companies listed on the Tokyo Stock Exchange and so is useful when attempting to predict the fortunes of the JPY. Unlike the above examples, the Nikkei Average is price weighted, meaning a company’s influence on the index’s overall score is proportional to the price of its shares. The 225 companies chosen to be tracked by the index come from a wide variety of sectors and the selections are reviewed once per year.
- The EURO STOXX 50, as the name implies, comprises the 50 most liquid stocks from across the Eurozone market; as of 2020, the index is dominated by France and Germany, which each account for slightly over a third of all assets. The EURO STOXX is weighted by free-float capitalisation and is characterised by a fast entry and fast exit selection system, ensuring only the most popular stocks are included in the calculations, and as such is an important one to be aware of for traders who favour the EUR.
Further reading: https://www.dailyforex.com/forex-articles/2019/01/how-falling-stock-markets-affect-the-forex-market/108576
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