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Trade Desk Thoughts:
Why Do Shares Decline On Positive Data?
Price action has been strange over the last two weeks. First, it was the NFP report, which despite the excellent numbers, has failed to move the market anywhere higher. Moreover, the market actually saw a short-lived sell-off in the days following the labor market report.
Fast-forward a week to last Friday, the currency market entered in to a strong risk-aversion mode, while the equity market failed to move anywhere, despite another very bullish report: U.S. retail sales. Therefore, the big question is, why is this happening since equities should surge while the dollar tumble on signs that the economy is improving?
Before answering this question, we need to go through a little financial theory. In the options market, traders use the Black–Scholes and the binomial model to find the theoretical price for a Call or Put. In the bond and futures markets, the price is determined based on future cash flows. A similar approach is used for the equity spot market, the current theoretical price is based on its future cash flows, meaning that the price of a share is dependent on upcoming dividends, but at the same time, it depends on how much the company has to pay to obtain capital. As such, the world of financial theory has come up with the Gordon growth model, used to find the theoretical price for companies.
P = D/(k-g)
Where P is the current theoretical price, D is the dividend paid by the company, k is the cost of capital, while the g is the dividend growth rate. From the formula, we can extrapolate that the bigger the cost of capital k is, in ratio to the grow dividend rate g, the smaller the price of spot share is. In another words, a higher interest rate (the cost of capital) puts downside pressure on the value of shares.
Returning to our story regarding why good news does not send the equity market higher is simply because the market is considering that, the economy is improving at a faster pace than previously thought, something that will allow the Fed to raise faster. This increases the cost of capital that companies have to pay, thus putting downside pressure on stocks. However, a very big exclamation sign is needed here: in the equity market, this is only a short-lived effect because positive reports (thus an expanding economy) will also increase the dividend growth rate and the dividend by itself, thus raising the value of the company.
On the other hand, in the foreign exchange market the case is completely different. Since March the dollar index has been in a strong downtrend because investors were thinking that the interest rate spread between the dollar and the other G-10 currencies will remain negative, meaning that investors will incur negative costs for carrying dollar positions.
All this has changed over the last few weeks since the U.S. economy is showing strong signs that it is emerging faster than the Euro-area or than the U.K. from the global slump. This means that the interest rate spread between the dollar and the euro needs to readjust accordingly to the current market’s expectations, higher interest rates coming from the U.S.
In particular, this does not necessarily point to a long-term downtrend on the EUR/USD yet, but it does show that the market is in a retracement mode for the time being. Now it is too early to provide specific data on when the market is going to turn around, or if it is ever going to turn around, but unless the Euro-area economy shows some sings of growth on its own, the trend will remain short lived.
It is very interesting to see how the market’s discount mechanism works. The current dollar strength started on Dec 03 09, just one day ahead of he NFP report. Since then the
EUR/USD has shed 400 pips (2.6%), the GBP/USD lost 400 pips (2.4%), and the AUD/USD lost 130 pips (1.4%), while the USD/CAD stood still.
Interestingly, trying to value the current economic strength, we could obtain a similar ranking. The Euro-area and the U.K. economies appear the weakest, the Australian economy is looking very robust while the Canadian economy is now walking hand in hand with the U.S. economy.