The Correlation Between Stocks and Forex

The post The Correlation Between Stocks and Forex by Jordan Robertson appeared first on Benzinga. Visit Benzinga to get more great content like this.

The foreign exchange (forex) and stock markets are completely different financial markets. Despite that, they may still display correlated movements, although that may not be readily apparent to the casual observer. 

In theory, if a nation’s economy and stock market outperform those of other nations, then the currency of that country should show increased demand relative to other national currencies. Conversely, if the reverse were the case, then that nation’s currency would be in lesser demand and therefore decline relative to other currencies. 

While that might make theoretical sense, various other practical factors determine whether or not a significant stock and forex market correlation exists. Keep reading to find out more about the correlation between stocks and forex markets. 

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Do Stocks and Forex Correlate?

Before discussing whether a forex stock comparison exists that can lead to a valid market correlation you can use when trading or investing, let’s first define each financial market:

• Stock market: The stock market consists of a marketplace where equity securities are bought and sold. Stocks represent ownership in companies and are listed for sale on the stock market, which provides a forum for individuals and companies to buy and sell stocks. Stock markets tend to be centralized, which means that stocks generally trade in domestic equity markets on an exchange like the New York Stock Exchange or the Nasdaq Stock Market.  

• Forex market: The foreign exchange market consists of a decentralized marketplace where currencies of different countries are bought and sold. Unlike in the stock market where you purchase and sell an asset for a certain amount of money, forex trades involve an equal exchange of assets. In other words, when you purchase one currency, you simultaneously sell another at the prevailing exchange rate, so you’re essentially taking a short position in one currency and a long position in another.

The correlation between markets can be either positive or negative. When positive, the correlation shows both markets appreciating or depreciating in tandem. In contrast, a negative correlation indicates an inverse movement in one market in relation to the other. 

The strength of a nation’s stock markets and the health of its economy typically have a direct correlation, which can lead to a discernible forex stock correlation. The valuation of a country’s currency against other currencies may vary, however, because the other nation’s economic situation and fundamentals will factor into the exchange rate of that particular currency pair. 

Some Correlation Does not Mean Positive Correlation

The broad U.S. stock market has typically demonstrated a positive correlation with dollar-based currency pairs, which means that the U.S. stock market usually rises when the U.S. dollar does and falls when the dollar declines. This tendency reflects the strength of the U.S. economy. 

Possible exceptions include narrow blue-chip indices like the Dow Jones Industrial Average (DJIA) because most large publicly traded U.S. corporations tend to be multinational. Such companies do a considerable amount of business outside the U.S., so the value of the dollar can make a big difference to the company’s bottom line. 

If the U.S. dollar shows significant strength, then profits from such companies’ foreign operations tend to decline, which would in turn have a negative effect on the price of their stock. Hence, although a correlation may exist, stocks of this type may actually show a negative or too weakly positive correlation with the dollar to generate a reliable trading signal. 

On the other hand, some market indices may correlate more strongly with certain currency pairs. An example would be the broad S&P 500 stock index and the USD/JPY (U.S. dollar/Japanese yen) currency pair. The chart below shows how these assets correlate.

A chart of USD/JPY in black versus the S&P 500 Index (SPX) in blue showing the correlation between the 2. Source: FOREX.com.

While a positive correlation may appear quite strong in some areas of the chart, divergence or negative correlation also can be seen in some time frames, which reduces the overall correlation between the assets. A clear predictive signal for either asset might therefore be difficult to discern for a USD/JPY or SPX trader. 

How Currency Values Affect Industries

In general, if the currency of an economy weakens, then domestic industries that export products become more competitive in foreign markets, which could positively affect the bottom line of companies operating in such industries. In fact, many transnational corporations benefit from strong currencies in the countries they do business in or export to. Conversely, if an exporter’s domestic currency strengthens, then it would be less competitive abroad. 

As a result of the impact that forex rates can have on their business, many multinational corporations hedge their currency exposures with forwards or option contracts. This helps prevent unanticipated exchange rate movements from affecting their bottom line.  

Some currencies can be affected by commodity prices because of the industries located within their issuing country being substantial importers or exporters of those commodities. The currencies of several countries with resource-based economies, such as Canada, New Zealand and Australia, are commonly known as commodity currencies for this reason. 

The value of commodity currencies can be significantly affected by moves in the relevant commodities produced in or used by those economies. For example, Canada exports oil and gold, while Australia exports gold and New Zealand exports food products and wood. If the price of a commodity a country exports increases significantly, then that country’s currency also tends to appreciate. 

How to use Stocks and Forex Correlations 

Market conditions and the nature of a company’s business generally play an important role when you are selecting a stock to trade or invest in. Furthermore, an in-depth fundamental analysis of a stock and its underlying company could reveal that the company has substantial foreign exchange exposure and what methods the company uses to hedge that risk. 

The exposure the company has in each national currency can sometimes even determine whether or not the company is profitable in that region. In general, if the U.S. dollar is trending higher, then a U.S.-based transnational company would probably be better off hedging its foreign income. Conversely, the corporation might benefit from remaining unhedged in a declining dollar environment. 

As an example of how forex rates can affect a major corporation’s stock price, consider the case of a company like Procter & Gamble Co. (NYSE: PG).  A strong euro and a weak dollar environment would typically benefit P&G — and hence its stock’s price — because it manufactures a substantial amount of its products in the U.S. This positive correlation arises because sales of those products in the European Union (EU) for euros provide a larger U.S. dollar return when those euros are sold or translated back into P&G’s domestic currency. 

Also, P&G’s largest competitors are Swiss-based Nestlé S.A. (OTC: NSRGY) and United Kingdom-based Unilever plc (NYSE: UL), which manufacture many of their products in the EU and the UK. This makes their products more expensive to manufacture and gives P&G a competitive edge when selling its U.S.-made products in the EU.

Conversely, a strong U.S. dollar would benefit P&G’s competitors and negatively affect P&G’s bottom line. This is because P&G’s products would cost more to manufacture in the U.S., thereby making them less competitive abroad, while the euros received for its products would be worth fewer dollars in a weak euro environment.   

Benzinga’s Best Online Forex Brokers

The best online brokers for trading a stock and forex correlation strategy would typically have to provide access to trading in both markets. Benzinga has compiled a list of the best brokers for this sort of strategy below. 

Is Trading a Forex-Stock Correlation a Viable Strategy?

While changes in the forex market can sometimes affect a stock’s price, any such correlation between the 2 markets may not be the best indicator for timing a stock purchase or sale. Observing a correction of this type also does not substitute for performing an in-depth fundamental analysis on the company before trading or investing in it. 

Some forex-stock correlations can be well worth the effort, however, on an individual stock basis. Large publicly traded companies with substantial foreign exchange exposure might be good targets to consider for a forex-stock correlation strategy, although fundamental research and some technical analysis would generally be necessary to support using a correlation of that type in your trading or investment strategy. 

The stock index market might also be a promising place to use the stocks and forex correlation trading strategy. For example, both the USD/JPY currency pair and the U.S. Dollar Index (DXY) tend to correlate positively with the S&P 500 index. A correlation trader could therefore trade the spread between those assets, selling the spread when it expands well beyond its average level and buying when the spread contracts excessively.   

Frequently Asked Questions

The post The Correlation Between Stocks and Forex by Jordan Robertson appeared first on Benzinga. Visit Benzinga to get more great content like this.