Should you buy or sell US stocks based on market correlations?

Like it or not, everyone traded the stock market in 2022. This is because the correlation between the US stock market and the other asset classes was so strong that it depended on where stocks will go next.

Take the EUR/USD and the S&P 500, for instance. The two moved in tandem, dropping as the US dollar strengthened.

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If we filter out all the noise from daily headlines, is there anything a technical trader may conclude after seeing the direct correlation between the two markets? One thing appears to matter the most – which market of the two (i.e., S&P 500 and EUR/USD) is leading, and which is following?

Is EUR/USD leading the S&P 500?

One thing is clear. The chart above shows that both the S&P 500 and the EUR/USD have declined in 2022.

More precisely, the former dropped by -9% and the latter by some -18% YTD.

But can the technical trader use the two markets to gain a competitive advantage regarding which one is leading and which is following?

Divergences should help.

If we look at how the two diverged, we may say that the EUR/USD is leading the S&P 500 and not the other way around.

Starting from left to right, we see the EUR/USD making a new lower low sometimes during the summer – shown in blue on the chart above. However, the S&P 500 did not follow.

Instead, the S&P 500 broke above the previous lower high, something that the EUR/USD did not. Moreover, the EUR/USD then posted a new lower low, and the S&P 500 index was quick to follow.

This brings us to the current price action, which is even more interesting. The S&P 500 made a new lower low this time, but the EUR/USD did not.

In other words, if we are to interpret the chart based on what happened earlier this year with the correlation between the two markets, then the EUR/USD should lead the S&P 500.

To sum up, the EUR/USD is now above the previous lower high, which means that the S&P 500 should follow. That means a target for the main US stock market index of 4,330 points.