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What to do When Prices and Fundamentals Just Donít Add Up
12 Oct, 2012
by Kathleen Brooks

This is one of the most frustrating situations for a trader. You think you understand the economic back-drop and you have a brilliant case for why a currency or a stock should move in a particular direction and then they move exactly the opposite way. 

The summer rally is a prime example. Who would have thought that the markets would be poised to rally if Spain was to request a bailout? Now that the ECB has put in place its bond-buying OMT programme the markets have decided that a Spanish bailout is a risk positive event even though Spain has the fourth largest economy in the currency block, its growth is in free-fall and the Eurozone’s creditors have no firm grasp how large Madrid’s liabilities will be. Likewise, public policy uncertainty is close to an all-time high in the US. The fiscal cliff is fast approaching and yet the SPX 500 is at a 4-year high and the Nasdaq is close to its highest level since 2000. So what is a trader to do: do you follow the crowd or risk losing all your capital by sticking to your instinct that the rally is false and will eventually sell off?

At these times the best traders remember that the market can remain “wrong” for longer than you can remain solvent. But rather than ditch your fundamental strategy altogether, the best thing is to put it on the back burner and adopt another interim strategy. During these periods I like to determine the most reliable lead indicators for the markets that I am following and then use technical analysis to make the most of the opportunities currently presented to me.

Let’s look at the first point about leading market indicators. My favourite lead indicators for US markets include the Dow Jones Transport sector index, the Apple stock price and Starbucks. In recent years I have also used peripheral bond markets in Europe as a litmus test of overall market sentiment. The reason why I look at the transport sector is because of Dow Theory. This states that the transport sector is a good indicator of future economic growth, since when the economy is expanding goods are being transported around the country and transport stocks tend to rise before the rest of the market. These days the strength of middle class consumption is also a good lead indicator, hence why Starbucks and Apple are on my radar. Added to that, the Eurozone debt crisis has been a key driver of volatility in the last 2.5 years, which is why I check Spanish and Italian bond yields when I get to my desk every morning.

Rather than base my trading decisions on my gut, and risk my gut being wrong, I use these lead indicators to determine my trading decisions. For example, if I see the transport sector starting to rise yet the SPX 500 is still falling, I would consider entering a long position once I had a good risk management plan in place.

Looking at Apple’s and Starbucks’ share prices can also give me a sense of overall market sentiment. After surging to its highest ever level, Apple stock had a pullback at the start of October. The stock price didn’t fall off a cliff, but there was some hesitancy in the market about pushing this stock above its $705 high reached on 21st September 2012. Apple found support at $650 and was trading sideways. This tells me two important things: 1, the market could be indecisive. Apple is a mega company, and it is a good gauge of overall market sentiment. If its stock price is not going anywhere then you could bet that the rest of the market is treading water too. Because it is such an important part of the stock market it would be hard for there to be a rally or a sharp sell-off if Apple was not involved. 2, The support and resistance levels that I have identified are good markers to determine potential future trends in the markets. For example, if we can break above $705 then it would suggest that the rally is still on. Alternatively, if it breaks below $650 then the up-trend may be over and there may be further momentum on the downside.Let’s apply this to the current macro backdrop. The outcome of the fiscal problem in the US – the expiry of $600bn of tax cuts and spending programmes in January 2013 – is unknown at this stage. The Presidential election in November complicates this matter even more as we don’t even know who will be in power when the US reaches the cliff edge. Hence no wonder markets appear to lack direction.

Right now there appears to be an even chance of either muddling through or going over the edge, which could plunge the US economy into recession. Stocks had a good rally over the summer months and yield is hard to find in the current economic environment of low interest rates, so people may be unwilling to give up on the equity market quite yet, even though there is this huge bout of uncertainty lurking on the not too distant horizon. If you short the market then you risk losing your capital, as the rest of the market may not move with you, if you go long you may be preparing yourself for a fall. So what should you do?

Instead of trading how about preparing a strategy? Some people tend to think that they have to trade all of the time and if they are not they are wasting time. I disagree. In an environment where the fundamentals don’t match up with the price action I would be lining up my leading indicators so I always have them in easy reach and doing my technical analysis. I want to find the current support and resistance levels that will essentially act as buy and sell signals that I need when I place trades in the future.

A trader’s fundamental analysis needs to be good in this game, but a precise trading strategy is key and that is where technical analysis comes in.

Kathleen Brooks can be contacted at Forex.com

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