I believe that the tight correlation between DX and EUR/USD comes as no surprise to those actively trading FOREX (Fig.1). This makes total sense. The index is made up of the Euro which has a 57.6% weight. In order for any other currency correlated to DX to have a major impact, there has to be some super powerful movement (JPY - 13.6%, GBP - 11.9%, CAD - 9.1%, SEK - 4.2%, CHF - 3.6%). So, what we need to do first in order to figure out where the U.S. Dollar Index is likely to move next is to analyze the dynamics of the Euro against the U.S. dollar and its correlation with other currencies.
But what about the S&P 500 index then? There are no such stocks that would be at least 10% of the index, which means they are unable to have a huge impact.
The question that is often discussed is whether the index or the stock leads the way. It is essential to have an understanding of this.
If the stocks drive the index, it is important to figure out the ratio of the majority of them and their movement correlated within a given time frame. Conversely, if the index drives the stocks, then the index will have a profound impact on the majority of issuers included in it. Based on statistics, 70-80% of the stocks follow the index, some are correlated, while the others are sensitive to the news imbalances (report or individual news) with their internal game until the emotions subside.
The truth lies somewhere in the middle, since both individual stocks, which in their entirety drive the index, and the index itself are purchased through ETFs, futures or options.
Hence, when trading a specific stock in terms of which the «news dust» has already settled, you need to clearly understand where the index is headed, where the key prices are, what is happening to the sector, and only then can you do a technical and fundamental analysis of the stock. The same logic applies to the index - by knowing the direction in which the majority of the stocks are moving, you can see a bigger picture of the current dynamics and near-term prospects.
However, the reader may wonder how one can factor in the impact of all 500 stocks. With this in mind, I used an example of the relationship between DX and EUR/USD pair at the beginning of the article. In other words, all we need to do is take the first 30–40 stocks of the index, which will have a similar impact on the S&P 500.
Just to illustrate this point, in Figure 2, there are first 10 stocks only which already form 22.36% of the index and undeniably have a great impact, while the index affects the stocks in return.
We shall take the first 36 issuers to prove the cross impact as exemplified by EUR in DX, and leave out a number of companies with non-halal and non-kosher businesses, since we don’t want the people from our wide audience to wonder whether it is possible to get the stocks of these companies. The stocks that have been left out won't have a major impact on the index, since there are not that many of them.
In the next articles, I will be reviewing one particular stock at a time, covering description of the business, the fundamental and technical aspects, attractiveness of the dividends, sector and fair value.
This series of articles is intended to help the trader or investor to avoid trading blindly just for the love of the game and adrenaline, but to be able to understand the stock analysis algorithm. Aside from the analysis, it is obviously not easy to demonstrate the degree of information review which we examine together with students. However, the further course of actions will be outlined, and you will be able to make more thorough decisions, build scenarios and understand the logic behind it all.
Author: Viktor Makeeu