The Inside Scoop on Outside Markets

 | Feb 21, 2012 | 2:30 PM EST
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The terms "risk on" and "risk off" have been commonly used (or, as some believe, abused) for several months as a way to describe the general tenor of investing in the daily marketplace lately. Most individual markets' daily price movements are interrelated to some degree, and more sessions than not they are influenced by just three key markets. Indeed, veteran market watchers can scan these three individual markets' price action early in the morning to get a good sense of how the entire marketplace will trade for at least the early part of the session. I'll explain these three key markets -- called "outside markets" by many -- and their daily effects on the entire marketplace.

U.S. Dollar Index

This is a basket of six major world currencies weighted against the greenback. Dollar index futures are traded on the Intercontinental Exchange, or ICE. This index is a good barometer of the overall health of the U.S. currency on a worldwide basis and is arguably the most important "outside market." The U.S. dollar and U.S. dollar-denominated government securities (Treasury bonds, bills and notes) are viewed by the world market place as one of the safest, if not the safest, assets to own during times of keener economic or geopolitical uncertainty. For example, if a major overnight development occurred in the Middle East, such as a military conflict, it's likely that the U.S. Dollar Index price would be significantly higher due to safe-haven investment demand for greenbacks worldwide. This would also be a "risk off" trading day, whereby investor risk appetite has shrunk due to keener uncertainty in the marketplace.

Crude Oil

Oil is a major, fungible commodity that is in strong demand worldwide. It's also deemed to be a "risk asset" by investors, as opposed to the safe-haven asset U.S. dollar. The daily price movements in crude oil futures significantly affect most other raw commodity futures market prices on that given day, and have a somewhat lesser influence on the world stock, currency and financial markets. On a trading day when crude oil market prices are trading higher, it's also likely that the U.S. Dollar Index will be trading lower, or at least experience minimal price gains. This is also called a "risk on" trading day, when investors seek out riskier assets such as raw commodities and stocks.

U.S. Stock Indices

The three major U.S. stock indices -- the S&P 500, Dow Jones Industrial Average and Nasdaq -- are the final outside market force. When the U.S. stock market is solidly lower on any given trading session, then it's a "risk off" day that will likely see lower crude oil prices and gains in the U.S. dollar index.

What's important to remember is that  the general correlations among individual markets, the three major outside markets, and their price movements is not constant and can sometimes turn 180 degrees from normal during unusual circumstances. For example, if there were a major military flare-up in the Middle East, initial market reactions would very likely be a spike up in crude oil prices and a big rally in the U.S. Dollar Index -- just the opposite of their normal daily trading relationship.

Still, a daily examination of the three major markets mentioned above provides the trader/investor with a good, general view of the mentality and "riskiness" of the marketplace on that given day. For more active traders and investors, it's a very helpful guide for that day's investment decisions. For the longer-term investor, the daily postures of the three key outside markets are less important.

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