Thursday, December 03, 2009

Lessons for Developing Traders: What Moves Markets

This is the first post in a series that I'm directing toward developing traders. I'm going to write about topics that no one told me about when I was learning the ropes. If that can help accelerate the learning curves of up-and-coming traders, I would be delighted.

So what moves the stock market up and down?

No, it's not chart formations, esoteric numerological series, or any of the multitudes of indicators that have been found to be non-correlated with future market movement.

Rather, stocks (aka shares or equities) represent a single asset class among a range of assets that include currencies, physical commodities, interest rate investments, real estate, and the like. All of these asset classes exist in various regions around the world: Europe, Asia, South America, etc.

Pools of wealth around the world seek the best returns for their money and migrate not only from asset class to asset class, but from region to region. Those pools of wealth migrate in large part in response to the fiscal (budgetary) health of regions, the monetary policies of those regions, and the economic prospects of those regions.

In other words, macroeconomic factors dominate investment decisions. If growth is perceived as greatest among emerging nations, wealth will tend to flow there. If interest rates are very low in the U.S. and U.K. and budgetary debt is soaring, investors will gravitate toward currencies where they can not only earn a better yield, but also benefit from favorable currency translations.

The largest pools of money come from large institutions, such as sovereign wealth funds and large mutual funds, hedge funds, pension funds, and the like. For the most part, those institutions are not daytrading their capital: they're trading/investing it over longer time horizons to profit from the trending movements that result from flows of international capital.

If you look at major turning points in the stock market, you'll see that they have tended to occur during periods when there were important shifts in central bank policies, often in response to economic strength/weakness and inflation/deflation. To be sure, the lead/lag periods of those macroeconomic shifts and trend changes in stock markets can be variable. Still, it's clear that, over time, tight monetary policies have tended to dampen stock market performance and loose policies have fostered stronger performance.

Much of what we're seeing in current markets is a flight of capital toward riskier assets (stocks, high yield bonds, commodities) due to the very low interest rate conditions that offer little return on safer assets. This is why the performance of so many asset classes has been highly correlated of late, with moves in stocks mirrored by similar moves in commodities, emerging market debt, and such currencies as the euro and Australian dollar.

In the past, such low interest rate/loose monetary conditions have tended to result in "bubbles": speculative excesses in riskier assets, such as we saw in real estate in the early 2000 period. Presently, given concerns over economic stability, rising sovereign debt levels, and tolerance of currency weakness, the greatest beneficiary of bubble investing has been gold. Not so far behind has been the stock markets of emerging countries.

As long as loose monetary conditions and low interest rates dominate the macroeconomic picture, we can expect to see higher stock prices as part of the flight of capital toward risk assets. It is when the consequences of the loose conditions become intolerable--politically and economically, either through inflation or defaults on bad speculative loans, that we see shifts in fiscal and monetary policy that lead to bubbles bursting.

We're not there yet. As we saw with tech stocks in the late 1990s and real estate in the runup to 2007, speculative excesses can continue for many years.

As an investor, my perspective is that we are in a business cycle bull market nested within a secular bear market that began in 2000. Like other secular bear markets (1929-1949; 1966-1982), this one has lasted many years and could go further. Like business cycle bull markets within secular bear markets, however (1932-1935; 1974-1976, 2003-2007), we could see considerable gains fueled by short covering and value investing. Indeed, we've already seen gains of 60% or so in major U.S. stock markets since the March, 2009 lows.

The key takeaway here is that markets tend to shift direction when nations change the direction of their economic and monetary policies. If everything stays the same, trends tend to stay in place. What moves markets in the big picture are macroeconomic shifts that cause investors to revalue world regions--and asset classes-- relative to one another.

So what does this mean for short-term traders? I'll tackle that topic in the next post in this series.


Milk Trader said...

Understanding the logic and rationale of how markets operate and why they move is far more interesting than pattern chasing fibo retracements and the famed head & shoulders pattern, which failed how many times this year?

This introduces the area of intermarket trading which, since being introduced by John Murphy, has yet to catch on.

Matt Fahmie said...

"Understanding the logic and rationale of how markets operate and why they move is far more interesting than pattern chasing fibo retracements and the famed head & shoulders pattern, which failed how many times this year?"

Understanding the logic behind the markets is the key to anticipating, visualizing and trading market structure. Structure is the last component of the market to form and thus if one is to wait for confirmation through structure his/her trade will be late as the market has already tipped its hand in the form of logic and time.

Fib retrace and head&shoulders are patterns conceived by the irrational mind and hold no logical basis thus the reasoning for their failure.

Excellent post Dr. Bret
and thank you for the recognition it is greatly appreciated. Seeing my work get recognized by people I look up to in this business only fuels my rage to master the art of trading.

Personal said...

The knowledge you have, share and the way you explain it are very valuable to me. Thanks a lot. And I love your book The Daily Trading Coach. Never wrote anything so far, was about time. So, again, thanks and keep going with this, there is too much teaching about mystic chart formation BS etc. out there and too little how to trade like many masters. I'm looking for better role models and you are on of them.

Redford said...

Hmmm, whatever happened to 'bet what you see, not what you think'.

Bob said...

I'd just like to make a quick comment. I don't understand why people criticizing a method of trading because they don't or can't understand it.

How do you think these patterns came about to begin with? It is because people began to realize that they had predictive qualities. The issue now days is everyone and their mother knows the classic patterns and the classic method of trading them. This by nature causes whipsaws, shakeouts, and outright pattern failures. Original strategies are required for these classic setups.

The failure of a pattern is often times a stronger signal than when it acts as expected. Don't believe me? Look what happened when the most talked about H&S pattern this year failed in early July. The market went straight up for several weeks after that!

This is a bit off topic so I won't continue. I am looking forward to your next post on this topic Brett!

VenEspeculador said...

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