part0029

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.

Having introduced two of the least understood and rarely analysed capital markets of bonds and commodities, I’m now going to explain the third of our four markets, equities. And once again consider their role in terms of risk, money flow, and the signals they send us as forex traders.

Moreover, equities also reveal where we are in the broader economic cycle. Also in this chapter I want to consider the role of volume as a leading indicator, and its importance in revealing market reversals.

Volume in the cash markets is the only activity which the market makers are unable to hide. And when combined with price, it becomes the most powerful indicator of future market direction. The technique of analysing the market with volume and price is sometimes referred to as volume price analysis. It's a technique that can be used in all markets and in all time frames.

Originally developed from markets where true volume is reported, such as equities and futures, it can also be applied to currency markets using synthetic volumes based on tick data, and gives an excellent approximation to true volume. After all, volume is activity and activity is volume.

Equity markets are all about risk and return. Higher risk assets yield higher returns, and if there is one sacred belief in trading and investing, it is that equities are the best asset class to hold for the longer term. The mantra is simple. Buy and hold and the returns will follow.

Whilst holding cash or government bonds may offer safety in the short term, these raise the prospect of another risk – inflation, and consequent erosion of any gains in real terms. However, anyone who had invested in the Japanese stock market over the last few decades may have a different view. The principle index, the Nikkei 225 peaked at the end of 1989, and is only just regaining these levels almost 30 years later. It would be hard to find a worse example of investing for the longer term, and here’s another.

Over the last 30 years up to 2010, US shares outperformed US bonds by less than 1% per year – hardly exciting, and certainly not enough to warrant the tag 'risk asset' and yet this is how equity markets are perceived, both by the markets and by investors around the world.

Therefore, until this view changes, equities will continue to be viewed as risk assets, short and simple. Investors buy equities when they are looking for better returns than in bonds or other conservative asset classes. If equity markets are rising, investors are prepared to take on more risk for 'assumed' better returns, so the money flow will be from bonds and safe haven currencies into equities and high risk currencies.

Conversely, when equity markets are falling, investors are moving into low risk asset classes and so the money flow will generally be into bonds and other low risk assets, along with safe haven currencies.

One of the key indicators used to measure and display risk, and the constant flip flop between so called 'risk on' and 'risk off' sentiment is the Volatility Index or the VIX. This is often referred to as the fear indicator, and is based on buying and selling in the options markets. I explain this in more detail later in the book.

The next issue when considering equity markets is rhetorical and it is this. Why do forex traders, rarely, if ever, look at the principle equity exchanges associated with the currency they are trading?

After all, if you are trading in a Euro pair, wouldn't you look at the main exchanges for Europe? The Euro, as we will see later, is a risk currency, so why not look at European equity markets for some clues, in a directly related risk market? This seems to makes sense to me, and yet most forex traders rarely think of this simple truism, remaining firmly glued to one screen and one instrument, oblivious to what is going on in directly related capital markets.

And when I say directly related, I am referring to the currency itself. Again, this seems to pass most traders by. For example if Japanese investors believe equity markets will offer a better return, money flow will be out of the Yen currency and into equities. The Yen will be sold, and equities bought.

Therefore, if you are trading the Yen wouldn’t it make sense to know what is happening in the Japanese equity market. After all, the yen is considered to be a safe haven currency, and if the money flow is out of the yen and into risk assets, perhaps this is an important piece of information, which only takes a few minutes to establish?

These are the major exchanges which account for around 90% of all equity transactions daily. However, when considering equity markets most traders (forex included) simply follow the ones mentioned in the media. Unfortunately, in most cases these reveal little, if anything about the economy of the country concerned.

For example in the UK the index that is always reported is the FTSE 100. What does this tell us about the UK economy? The short answer is nothing. So why is this index the one that is only ever reported?

The answer to this question is simply laziness by the media. In reality the FTSE 100 index is the least representative of the UK economy. More than 70% of the profits of companies that make up the index come from abroad, and whilst the index consists of companies quoted on the London Stock Exchange, there is nothing particularly British about any of them.

Several of the current companies such as Antofagasta, Fresnillo and Rio Tinto have no activities in the UK market whatsoever. Other more familiar companies such as Shell, BP, BAT, Unilever and Glaxo, derive most of their business and profits from overseas. When we look at other exchanges around the world we have a similar problem.

The US equity market is always quoted based on the Dow Jones Industrial Average, and yet the Dow only consists of 30 US companies, and is hardly representative of the US economy.

On the other hand, the Nikkei 225 is far more representative of the Japanese market, with almost all of the two hundred and twenty five companies being Japanese, and primarily based in Japan.

Meanwhile in Europe the Euronext 100, is composed of European companies and therefore provides a more realistic reflection of the European economy. Canada too takes the same approach.

In the UK this is certainly not the case, therefore in order to gain a more balanced view of the UK economy we need to watch the FTSE 250 or even the FTSE 350. In the US, we need to watch the S&P 500, or the NASDAQ, not the Dow 30 which is far too narrow in scope.

In simple terms, equity markets serve as a basic measure of risk, whether over the longer term, where significant changes in the broad economy are reflected, or on an intraday basis, where sudden changes in sentiment are signalled in the price action, with consequent sudden changes in money flow out of risk and into safe haven assets.

The primary index to watch during the US trading session is the S&P 500 index, and with approximately 75% of companies listed having a very strong US connection, can be considered to be a good proxy for the US economy.

Once US markets have closed, equity futures then provide a view of risk, heading into the Asian session, where Japan's Nikkei 225 index becomes the standard, with the Hong Kong Hang Seng index and China's CSI 300 providing alternative views for the Far East markets. The Australian All Ordinaries Index then takes up the baton, before moving to Europe with the DAX, the CAC 40 and finally to London.

In terms of pure currency relationships between equity markets and the associated currency, the two markets most closely watched by traders are US equities and Japanese equities. And the reason for this is very simple.

Both the currencies associated with the US and Japan, namely the US dollar and the Yen, are considered safe haven currencies. And this is something we will explore in more detail later. As a result, the associated flow of money into exchanges where these are the 'home' currency are particularly revealing when considering market sentiment.

After all, yen buyers will be buying to reduce risk with a safe haven currency. Yen sellers will be selling to increase risk by moving into equities and other risk markets.

This is revealed in the price action for the Yen against the price action for the associated index, in this case the Nikkei 225. This effect may be further magnified by effects within the currency markets themselves, where the yen is generally used as the low interest rate currency in the ever popular carry trade, of which more later.

Just as we have already seen with bonds and commodities, there are additional key relationships which exist with equities, and the one I will be covering in detail in a separate chapter is the relationship between equities and bonds.

As you would expect this is yet another of the principle relationships between capital markets, which this time defines the extremes of risk. On the one hand, we have equities, which are considered high risk, whilst on the other, we have bonds, which are considered low risk or conservative, and this is a relationship best imagined as a see-saw. Whilst the relationship is one of money flow from one to the other, it is far from straightforward, and certainly not linear as we will see.

At this stage of explaining equity markets and their importance to us as forex traders I would like to introduce two other key analytical tools. The first is sector rotation, and the second is volume. Again these are covered in more detail later in the book, but I have introduced them here for completeness. So let me begin by introducing the concept of sectors and sector rotation.

All the major exchanges around the world allocate stocks to various sectors. Just like any other asset or instrument, each sector is represented on a chart to which we can apply technical analysis techniques in order to analyse the price action, and draw conclusions about the strength or weakness of each sector. These sectors tell us a great deal about the economic cycle and current environment, as different sectors do better at different stages of the economic cycle. This is referred to as sector rotation.

For example, towards the end of an economic expansion, the energy sector and energy stocks will generally perform well, normally due to rising energy prices and a consequent build up of inflationary pressure.

In the early stages of economic recovery and expansion, as we are likely to see in the next few years, interest rate sensitive stocks are likely to perform well, with technology stocks often the first to signal a recovery from recession as companies begin to spend on capital equipment once again.

The key index here is the NASDAQ 100. This area of analysis of equity markets is one which is often overlooked, even by those trading equities. Yet it provides more clues as to the economy, the economic cycle, and in turn likely policy decisions by the central banks.

Finally in this chapter on equities, I would like to introduce another key analytical tool which we use in many ways across different markets, but particularly when analysing equities, and is what I call volume price analysis. Or VPA, for short.

I have been using this technique for many, many years not just for analysing stocks for investments, but also as a tool to help me forecast both short term and longer term turning points in equity markets, which then signal changes in the money flow to lower risk assets. This technique can be applied in any time-frame, so even if you are a scalping trader, it can be applied to a five minute chart of the S&P 500.

Let me give you a quick example of how to use this analytical tool. Suppose for a moment an item of economic data has been released, and you are watching the S&P 500 for market reaction.

On the 5 minute index chart you see huge volumes coming into the market. However, this is associated with weak price action. In other words the price is not reflecting the activity in the market. In fact, the market begins to fall on rising volume, a sure sign of short term weakness.

Simultaneously, bond yields are ticking lower as money moves into short term bonds. You can now start to look for signals in the currency markets of money flow into safe haven currencies and take advantage accordingly. Your risk assessment on a potential trade, has all stemmed from your assessment of volume in the equity markets.

As a forex trader this becomes an even more powerful tool, as we have no equivalent volume in the forex market which is one of the many reasons why trading currencies is so difficult. Therefore, let me just digress and explain about volume for a moment with regard to the forex market.

This market has no central exchange, so there is no 'real' volume reported, unlike the equity markets where volume data is collected on all transactions and reported for the cash markets, as well as in the futures market.

However, there is a solution. For the spot forex markets we use tick data as a proxy for volume, and it is generally agreed that this is a 90% approximation to true volume. Later in the book I explain tick data and how we use it in more detail, but for the time being all we need to know is we have two sources of volume data for analysis. One is based on real volume in equity markets. The other is based on synthetic volume using tick in the spot forex market, giving us two views to compare and contrast to judge risk, money flow and market sentiment.

In the cash equity markets we have volume reported second by second and minute by minute. Volume tells us a great deal as it reveals the true activity in the market and whether the market is participating in the move. In other words is the price move genuine, and if so, it will be seen in related markets. If the move is false, it is a fake move. These moves happen all the time as the market makers in equities test the market with price action, pushing indices back and forth to test support and resistance levels and to trap traders into weak positions.

The power of using volume and price (VPA) comes when we combine our analysis of the volume with the associated price action, which reveals what the market is thinking, and ultimately what is happening as a result.

Volume price analysis is equally valuable for other markets and instruments. Futures for example report true volume. ETFs, which I mentioned in an earlier chapter, report trading volumes. So it can be used in some of the ETFs we track to tell us what is happening in commodities or currencies. Or even in some of the market internal indices that are so important, and which will be covered in more detail later.

Suppose we see an equity index has reached a key technical level, but then begins to move sideways. On one particular day we see a narrow range candle, but with very high volume. What message is the price action and volume giving us?

It's a very simple message, the volume is signalling weakness because if the market were strong, the price action would have been wide and the market would have moved higher, out of congestion. Clearly the market is not interested in further buying at this level and is resistant. The buyers are moving out and have lost interest. If there were more buyers than sellers the market would have risen higher – here the sellers are selling into a market with few buyers, so the price remains in a tight range.

This is the simple concept on which volume price analysis is based. We look at the volume and then compare this with the price action on the chart which can be in any time frame. It doesn’t matter whether it is ticks, minutes, hours, days or weeks.

If an index or ETF is moving higher on very low volume, we know it is likely to be a trap up move by the market makers, and the money flow is moving elsewhere. Similarly, if an index or ETF is moving lower on very low volume, we know this is also a false move. This is the basic principle behind VPA which I cover in more detail for you once we get to the technical section of the book.

Equity markets are a perfect vehicle for assessing sentiment and risk. In addition they are one of the purest markets in terms of volume. However, we do need to ensure we are watching the most appropriate indices. And remember also, we can follow these markets 24 hours a day in two ways. First by tracking each physical exchange around the world as they open and then close several hours later. Second, we can follow the futures indices on Globex which again is virtually 24 hours a day. Here you can follow the index futures which are traded on the CME on an electronic platform, so at any time of the day or night, there is either a physical exchange open somewhere in the world, and/or the electronic markets of indices. So between the two, we have a barometer of market sentiment always available and wherever we are in the world.