Can You Trade Successfully Reacting To The Economic News/Data?

The vast majority of blogs, newspapers, magazines, TV, Radio, and so on are devoted to the analysis and opinions of the latest numbers that are issued by various government agencies, trade bodies, etc. Not only that, but most commentators pontificate on the economy and the markets in a completely ill-informed way. Precious few devote any time to technical analysis discussions. The assumption is, of course, that it is the “News” that drives the markets up and down. But is this true? What follows and my conclusions may surprise you.

I have poured over many charts showing the performance of the financial markets since the beginning of time, and I can state:

  • There are times when stocks go up when interest rates are going up. And times when they go up when interest rates are going down.
  • There are times when stocks go up when crude oil is rising. And times when they go up when oil is falling.
  • There are times when stocks go up when the Trade Deficit is growing. And times when stocks go up when the Trade Deficit is shrinking.
  • There are times when stocks are going up when GDP is rising. And times when stocks go up when GDP is falling
  • There are times when stocks go up when company earnings are rising. And times when they go up when earnings are falling
  • Myth No 1: Inflation always makes Gold and Silver go up (there are times when gold is falling and inflation is rising)
  • Myth No 2: Central Banks control interest rates (look at a chart of Fed Funds and note when the Fed has changed rates – the market rate always leads changes in the Discount Rate!)

I could go on (you can check these facts for yourself from several websites).

If there is no causal link between these ‘obvious’ factors and the markets, then what does drive the markets?

Why Financial Markets Are Not Rational, But Emotional

First, you need to understand that conventional economics cannot explain market behaviour! They are two very separate fields. In economic theory, it is a given that demand for a product increases with falling prices (people will buy more newspapers if the price falls). This is taught in Economics 101 as the Demand Curve. But with financial markets, we have seen that very often, demand decreases (and supply increases) with falling prices. Selling begets selling, and buying begets buying. This is what gives us trends.

Most investors will look to buy more shares if the price is rising, and sell more if the price is falling. Professionals do the reverse! We traders must learn how to think like the professionals.

Furthermore, since the financial markets are auction markets, traders behave as they would at an auction house. Have you ever been to one? If so, you will notice that very often, when two determined bidders vie with each other for the object of desire, the bid price can rise and rise – and rise. As prices rise higher and higher, the emotions in the room (especially of the two bidders) rise as well, and mat well draw in more bidders. Rationality goes out of the window, and afterwards, people are astonished at the high price achieved, but most accept it as the ‘real’ value of the object.

Now, what would happen if those two determined bidders had chosen to play golf instead of attending the auction? Of course, the final price for the very same object would have been much lower. So, what is the true value of the object? Good question. Successful investors/traders know there is no such thing as ‘inherent worth’. This fact alone kicks the ‘rational market hypothesis’ out of the window.

That is something that is not considered by conventional economics, which assumes all players act rationally and have perfect information to base their decisions on.

If you understand that, you can see that most market traders do not act rationally, but emotionally. If prices are rising, some traders jump aboard because they don’t want to miss the action (they figure that the others know something that they don’t) – an emotional, not a rational decision.

We, as ‘rational’ traders, try to measure the emotionality of the other traders in order to anticipate their next likely move. Therein lies massive profits.

To be successful, we must become contrarians in some way.

All of us have a dual nature. Sometimes we can be ‘sensible’ and at other times we can be ‘outrageous’, and go against type. We are at the same time individuals and like to think we have our own self-will and have conclusions that we have arrived at ourselves. Then we are also a social animal and join in ‘crowds’ and behave in ‘herding’ actions. This herding instinct is a very basic one and none of us is immune!

This herding instinct shows up vividly and directly in the financial markets.

Let’s have a look at one entrenched myth: that higher inflation means higher Gold prices (I’m sure you have heard that “Gold acts as a hedge against inflation”). This is a prime example of a herding myth (most people join in without doing any basic research to confirm its validity).

In 1980, at the height of the 70s inflation scare, Gold was trading at an astonishing $850 (then, an all-time high). In the 21 years to 2001, Gold fell all the way down to $255. Was there no inflation in this period? Everything else rocketed in price from real estate, stocks, to art. Gold was the worst investment bar none during this period of booming asset prices (a measure of inflation) – and booming money supply growth! Most people have short memories in the markets.

So making a trading decision based on this myth can get you in big trouble. I have found the Gold price more closely follows money supply figures. But then, this aphorism doesn’t have the same ring! Today (Summer 2010), Gold is one of the only markets near its all-time high, as stocks, base metals, crude oil, real estate, are all significantly off theirs. It is the last hold-out of the Great Reflation Rally that western governments have done to try and prop up the markets. It is doomed to fail, by the way.

On a smaller time-scale, I’m sure you have noted times when markets fail to respond to ‘bullish’ or ‘bearish’ news. This is when commentators tie themselves up in knots trying to explain the unexplainable (at least, by conventional means). So much print and airtime is wasted, but that is what keeps employment up – and being cynical, keeps the mass of investors betting the wrong way!

What Drives The Markets?

OK, so what does drive the markets?  If it isn’t the economic statistics and ‘fundamentals’ inside the market environment, it must be factors outside, independent of the ‘conventional’ mechanisms!

And those factors are, for want of a better term, ‘mood of the market’, or ‘market sentiment’, driven by the herding impulse of mankind.  Of course, market fundamentals have a big role to play, but only indirectly – it is the market participants’ understanding of them in their herd that determines prices/values.

Our friend, Ralph Elliott, writing in the 1930s stated: ‘Current news and political developments are of only incidental importance, soon forgotten.  Their influence on market trends is not as great as is commonly believed’.  And that comes from the great man 80 years ago.  Today, things have not changed a bit, but the technology available for trading/investing and disseminating news certainly has!

Even academics have found that many of the biggest market moves in recent years have occurred on days when there were no major news events!

This is a stunning finding – so why do most of us continue with our discredited thought patterns?  Good question.   I propose that without these very human failings, we would not get the great trading opportunities that we find, as markets would not reach such extremes of valuation.

I believe the only sane way to trade is by being a contrarian thinker about the ‘news’ and trading on technical analysis, at least for the stock indices, currencies, gold.  (Naturally, we all need to keep an eye on the basic economic background.)  Of course, share prices of individual companies can (and do) react to announcements such as poor drilling results, increases in dividends, and so on.  But that is why I do not trade single company shares!  That is my choice – you may wish to, and you can use these methods here to do so.  But be careful!

Luckily for us, we can measure market sentiment in a variety of ways, but I shall focus on just one measure; the Momentum Oscillator, as we have seen.

It gives me most of what I need to make trading decisions.

The bottom line is that to be consistently successful, you need to have a solid strategy using technical analysis principles with good money management skills.

We will later look at two very powerful concepts that is the basis of my own trading – Fibonacci retracements and projections, and Elliott Wave principles.

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