Proof that Fundamentals aren’t Driving Market Prices
It’s been a long known phenomena that the world’s financial markets are highly correlated. This is much more true today than it was even just 10 years ago.
Generally, when European bonds rally, so do Asian bonds. When U.S. stocks are down (SH), so is the European stock market (VGK). When the Euro drops, gold (DUST) does too. What do oil prices have to do with financial stocks? Not much it seems, but nevertheless they are still correlated.
Another peculiar relationship that seems to hold even on a minute by minute basis is the Japanese Yen and the Carry Trade associated with it and the stock market. Even on a minute by minute basis, when the Yen strengthens generally the S&P is declining, and this has been going on for years, since the Yen’s (FXY) strength topped out back in late 2011.
It is rather easy to make the case through charts that the Yen has been driving the stock market’s rally since.
As a result, the Yen’s strengthening the last few weeks has also been the primary driver of the market’s selloff. What if the Yen’s 3-year trend of weakness is ending and the last few weeks is the new trend?
Causation or Correlation
We run a major risk of blaming something for causation when it may just be a highly correlated relationship. Perhaps what is driving the global markets isn’t the Yen or currency fluctuations. Perhaps it is the S&P that is driving the currency markets instead of the other way around? And, to be honest, I am not sure such a claim can ever be proved or disproved, but then again do we really need a weatherman to prove to us that the weather is currently good or bad? Sometimes it just takes a little peek behind the curtains.
I tend to dismiss claims that the correlation between the Yen and the S&P doesn’t matter because of the sheer size of the currency markets. Today, worldwide currencies trade over $4 Trillion each day! The equity markets don’t even trade $300 Billion each day!
The sheer size of the currency markets make them the gorilla in the room. If there is any asset class bullying any other one, it is currencies over the much smaller equities. Plus, just a quick peek behind the curtains, at the charts, provide all the proof we need.
Check out the chart below that shows the Yen versus the S&P over the last month. Is there any question the Yen and the S&P are highly correlated?
The S&P 500 it seems certainly isn’t driven by individual companies’ performances or your typical fundamentals. According to S&P, less than 1% of all revenues from S&P 500 companies even come from Japan.
So why does the S&P 500 care about the Yen so much? Could it be there are much larger, macro, drivers of the equity markets and we should spend our time elsewhere than worrying about the “fundamentals”?
WATCH: Why Corporate Balance Sheets are Getting Worse, not Better
One of the great privileges of being a technical analyst is we don’t always need to be interested in the hows or whys, just the realities. The reality is there are much larger things going on in the world driving U.S. equity prices than simple company earnings or revenues or even the Fed. Asset Allocation remains much more important than stock selection. Those things aren’t affecting the indices’ or your stocks movements. The Japanese Yen, for whatever reason, is, and we need to incorporate it into our forecasting in order to even attempt forecasting the equity markets.
Check out the longer term chart of the Yen below including the recent 3 year weakness.
What if the 3 year trend of Yen (YCS) weakness has come to an end and we are starting a trend of strengthening? Correlation histories and the chart above imply that would be very bad news for the stock markets around the world as we’ve seen what the above chart tells us when the Yen (YCL) strengthens.
The chart above shows that the Yen has fallen significantly over the last three years, but the recent rally that has occurred in the Japanese currency, you know the one that helped send the S&P down 9.5% already, may just be getting started.
The chart displays a few reasons to expect the strengthening Yen to continue. For one, a 15 year trendine was reached this month that indeed brought in buyers. In addition to that support, the Yen remains in a very long term uptrend, making higher highs and higher lows over the past 20 years. Although there has been major weakness recently, the greater trend is one of strength.
The momentum divergence shown at the bottom of the chart also suggests the last year of weakness in the Yen has not been built on a sturdy foundation. Typically when divergences form from such oversold levels, price works its way back to the levels of the original oversold reading. In this case that suggests at least Yen $98 (FXY), another 5% higher.
The recent Yen rally was a 4% move, taking equities down over twice that as the carry trade is unraveled.
Further unraveling should be expected to keep equities under quite some pressure, and if the Yen just made a long term bottom, watch out below equities.
The ETF Profit Strategy Newsletter follows the world’s markets to keep investors ahead of the game. This year we already prepared our subscribers for the tank of the Euro, the rally in the Dollar and Treasury bonds, the selloff in gold, surge in market volatility, and the pullback in equities. If the Yen can’t resume its trend of weakening, then it is likely equities will have a very tough time rallying, likely continuing their move lower.
Follow us on Twitter @ ETFguide
Related Posts:
