HomeTrading Lessons1. Market Analysis

Market Analysis

MARKET ANALYSISMARKET ANALYSIS RULES

Market analysis refers to the process of studying market fundamental data and measuring the dynamics of future demand and supply in order to identify risks and spot trading opportunities.

 

■ Think Long-Term and Invest in the Future

Invest in the future, not in the present. Focus on the big things coming in the future and ignore the small things happening today. As Larry Hite suggests you may not know what will happen tomorrow, however, you can have a very good idea of what will happen over the long-run.

Your decision-making should be based on events that will take place in the next semester, not on events that take place today and are already discounted by the market.

 

■ Create the Macroeconomic Picture of Tomorrow

Professional traders create a picture of the future macroeconomic conditions before making any trading decision. Paul Tudor Jones says: “If trading is like chess, then the macro is like three-dimensional chess. It is just hard to find a great macro trader. When trading macro, you never have a complete information set or information edge the way analysts can have when trading individual securities. When it comes to trading macro, you cannot rely solely on fundamentals; you have to be a tape reader.”

Thinking long-term is all about anticipating the macroeconomic environment of tomorrow. The main focus is on variables such as inflation, employment, interest rates, and the action of FED to deal with these conditions. All information is important. Create a few scenarios and seek confirmation using tools such as the FedWatch tool (target rate probabilities) and the Overnight Repo Rate.

» FedWatch tool

» Overnight Repo Rate (US)

 

■ Markets are Unpredictable, Imagine different configurations of the world and alternative scenarios

Successful traders have the ability to think multi-directionally and create multiple scenarios about what is going to happen. Creating different scenarios provides the opportunity to adapt to any future market conditions.

Bruce Kovner says: “I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen. One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed.”

 

 

■ Listen to what the Big Players are Saying, but Don’t Trust the Reports of Large Banks

Don’t try to explain market behavior based solely on what you know. The markets move before the news because there are others that know more than you. Bruce Kovner argues that: “There are thousands of difficult-to-understand mechanisms that lead the market, which come into play before the news reaches some poor trader sitting at his desk.”

It is beneficial to monitor what the big players are saying; they know more than you. However, don’t trust the reports of large investment banks (Morgan Stanley, UBS, etc.), they usually describe what they wish to happen in the market, not what they really believe will happen. If they want to sell the market, they will probably say that they are bullish, and if they try to buy the market, they will probably talk about hazards and risks. In addition, never trust politicians. Trust only individual gurus that have a proven record of speaking the truth, such as Ray Dalio and Paul Tudor Jones.

 

■ Markets are Never Wrong, Opinions Often Are, Be Ready to Change your Opinions

Any opinion must be confirmed by the market in order to have any value. For example, if you anticipate that the price of an asset is about to make a very important breakout, make sure that volume confirms this breakout. Until volume confirms this breakout, don’t trust price action.

Jesse Livermore argues: “Don’t trust your own opinion and back your judgment until the action of the market itself confirms your opinion. The human side of every person is the greatest enemy of the average investor or speculator. Wishful thinking must be banished.”

Furthermore, in a globalized economy, the macroeconomic conditions can change by the day. In such a dynamic environment you must always think flexibly and be willing to change your opinions to survive.

Joe Vidich says: “To be successful in the markets, you have to be willing to change your opinion. Most people are not willing to change their opinion. You have to be humble about your ideas.”

 

■ Price Trends Matter Only Within the Context of a Fundamental Landscape

In general, there are two types of market trends:

  • Speculative trends that last for a few hours to a few days, and then the price returns to its mean
  • Key price trends that last for a few weeks to a few years

The anticipation of a key price trend should reflect current or future fundamental events to make sense. If price movements do not reflect fundamentals, sooner or later the price will retrace to its mean.

As Colm O’ Shea says: “People get all excited about the price movements, but they completely misunderstand that there is a bigger picture in which those price movements happen. To use a sailing analogy, the wind matters, but the tide matters, too. If you don’t know what the tide is, and you plan everything just based on the wind, you are going to end up crashing into the rocks. That is how I see fundamentals and technicals. You need to pay attention to both to make sense of the picture.”

 

■ Knowing the Stage of the Market Matters the Most

You can easier make money buying an expensive asset in a bull market than a very cheap asset in a bear market. Identifying the stage of the market is helpful in pricing opportunities, calculating risks, and adjusting your position-sizing respectively.

Victor Sperandeo says: “Trading the market without knowing what stage it is in is like selling life insurance to twenty-year-olds and eighty-year-olds at the same premium.”

In general, there are two key cycles in the economy:

  • The Macroeconomic Cycle (last decades)
  • The Business Cycle (last some years)

You must be able to identify the current stage of the market before getting any exposure.

 

■ Focus Constantly on the FED and Liquidity

FED’s printer controls all markets by altering the level of liquidity. In the world of derivatives that we are living in, the level of liquidity becomes the most important fundamental variable. Here are some facts to get an idea about the gigantic size of the derivatives market (source: VisualCapitalist 2020):

  • Coins and Banks Notes, 6.1 trillion USD
  • FED’s Balance Sheet, 7.0 trillion USD
  • Gold Markets, 10.9 trillion USD
  • Stock Markets, 89.5 trillion USD
  • The World’s Money (M1+M2), 95.7 trillion USD
  • Global Debt, 253 trillion USD
  • Global real Estate, 280.6 trillion USD
  • Derivatives (Gross + Notional Value), 558.5 trillion USD

As the legendary Stanley Druckenmiller pointed out: “Earnings don't move the overall market; it's the Federal Reserve Board… Once an economy reaches a certain level of acceleration, the Fed is no longer with you… The Fed, instead of trying to get the economy moving, reverts to acting like the central bankers they are and starts worrying about inflation and things getting too hot.”

Lessons to be learned:

  • Central banks control liquidity and liquidity controls markets
  • In the mid-term, liquidity moves capital markets, not earnings
  • Always focus on the FED and what is trying to achieve
  • Keep an eye on projected inflation and interest rates

The grand cycle of liquidity moves between two critical inflationary stages:

  • Deflationary Stage (Central banks inject more liquidity in the system and hard assets thrive)
  • Inflationary Stage (Central banks withdraw liquidity from the system and hard assets tank)

 

■ Deflation Creates Asset Bubbles

As mentioned before, historically, the economy moves from inflation to deflation. Deflation forces central banks to increase the level of liquidity in the market in order to boost consumption and employment. Interest rates go down. That is the perfect environment for capital markets to create bubbles.

Stanley Druckenmiller argues that: “The way you create deflation is you create an asset bubble. Every serious deflation I've looked at is preceded by an asset bubble, and then it bursts.”

The bubble is expected to last until inflation returns. When inflation returns, central banks withdraw liquidity, and the capital markets tank. These are some early signs that inflation is about to return and you must sell hard assets:

  • The prices of industrial metals surge (NOT precious metals)
  • Energy prices surge

 

 

■ Bond prices and Stock Market are the Best Economic Indicators

The key macroeconomic data (GDP, inflation, spending, employment, etc.) are always lagging and cannot predict economic recession or recovery at an early stage.

Two reliable indicators for predicting the future economic conditions, at an early stage, are the bond prices and the stock market. Historically, the stock market is able to predict economic recovery long before it happens. Stanley Druckenmiller argues that: “Whenever I see a stock market explode, six to 12 months later you are in full-blown recovery.”

However, the most resourceful insight for the future economic conditions derives from the prices and the spreads of government bonds.

The spread difference between the 10-year and 30-year bond

As a general rule, the longer-maturity bond should pay a higher yield than a shorter-maturity bond. By measuring the spread between two different maturity bonds, we can make some important observations regarding where the economy is heading. These are the four (4) basic scenarios:

  • If the 30-year US bond yield is considerably higher than the 10-year bond yield, the smart money anticipates better economic conditions in the long-run
  • If the 10-year and 30-year bond yields are almost identical, the smart money anticipates that the economy is entering a transition stage
  • If the 10-year Bond yield drops considerably faster than the 30-year Bond yield, the smart money expects bad mid-term economic conditions
  • If the 10-year bond yield is considerably higher than the 30-year bond yield, the smart money anticipates a future economic recession

» https://ycharts.com/indicators/30_year_treasury_rate_less_10_year_treasury_rate

 

MORE» MARKET SENTIMENT | » TRADING RULES | » MONEY MANAGEMENT

 

MARKET ANALYSIS

George Protonotarios (c) February 2021

for CurrenciesFx.com (c)

 

Sources

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