Houdini often used misdirection to help him become one of the most famous magicians in history.  He would focus the audience’s attention on an illusion, so they wouldn’t notice what he did to complete his magic trick. 

Today, similar misdirection is used when trying to explain the stock market’s movements. The aim is to distract your attention on news and other illusions of today’s market when the real driver of price is completely different. Gerald Loeb alluded to this when he said, The most important single factor in shaping security markets is public psychology.

In this article I take a look at what really drives equity market prices and why you should avoid getting sucked into the drama concerning the Sequester, Bernanke’s testimony, housing starts, payroll surveys, etc and focus on the one thing that really is driving this stock market.

The Tail that Wags the Dog?

In an article I wrote on 10/3/12, about the importance of the Euro and how its movements are driving US stock prices, not earnings or other factors, was captured by one simple chart.

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The chart shows the more things change, the more they stay the same.  In October the Euro was in the driver’s seat and today, shown by the Euro’s tracking ETF (NYSEARCA:FXE), the Euro continues to be extremely correlated and a major driver of the US stock market’s (NYSEARCA:SPY) direction.

The Power Connection

Ever heard the saying, Money is Power?  Well when it comes to money, currencies indeed are a lot more powerful than equities. 

We live in a continuously more interconnected and global world.  Proof is shown by the immense size and growth of foreign exchange transactions with over $4 trillion traded on the currency markets every day. 

By comparison, the New York Stock Exchange (NYSE:NYX), the largest stock exchange in the world, trades around $150B each day.  That market is 3x larger than its nearest competitor, Nasdaq (NASDAQGS:NDAQ).  The top 10 stock exchanges ( ICE ) in the world trade an estimated $375B collectively each day.

This means the Foreign Exchange market is over 26x larger than the NYSE and over 12x larger than all the world’s major stock exchanges (NYSEARCA:GWL) put together.

To call the Forex market the bigger brother of the equity markets is indeed an understatement.  Given the correlations and size differences between the two markets, it is very safe to say that the currency market is the dog that wags the tail of equities.

Married at the Hip

In our Technical Forecast published twice each week, we recently noticed the Euro was topping out on Feb.10 at $1.3366 and provided the following commentary along with the below chart.

The Euro has now pierced its monthly pivot.  A break of the blue uptrend channel support trendline would likely provide a high probability sell setup as the uptrend since the November lows ends.  Given the prevailing bullish sentiment and commitment of speculators to a continued rally in the Euro, from a sentiment standpoint, the odds are indeed better for sellers of the Euro here versus buyers.

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The Euro has since broken its blue uptrend channel support at $1.3310, its downtrend has been confirmed, and its price now sits below $1.3100, a huge move in such a short time for a currency.

The global equity markets are still elevated compared to the Euro’s recent weakness as displayed in the first chart, and we feel this puts them (NYSEARCA:IVV) at increased risk over the next few weeks. 

The implications also would affect other markets such as the Dow Jones Industrial Average (NYSEARCA:DIA), long term bonds (NYSEARCA:TLT), and commodities such as Silver (NYSEARCA:SLV) and Gold (NYSEARCA:GLD) which we analyze in our Technical Forecast.

As the political drama of automatic U.S. spending cuts take center stage, keep in mind the real driver of U.S. equity prices.  To be bullish on stocks you likely also will need to be bullish on the Euro, and that looks like a very risky proposition.

A top down, more macro, approach is much more relevant in today’s market environment.  Avoid misdirection by following what really matters.  The ETF Profit Strategy Newsletter filters through the crowd’s noise by using comprehensive technical and fundamental analysis to keep us on the right side of markets.  A few times each week we update our subscribers on actionable high probability trading setups that identify stops and profit targets like those of the Euro and its tradable ETFs.