How the Markets CAN Move
As my last post, I'd like to leave an insight into the regularities and irregularities of the financial markets. Many times, we assume that markets should behave a certain way because it makes sense to behave that way. However, we forget that markets many times go haywire and pursue irrational ideologies that will inevitably need to correct themselves. Some of us try to fight this irrationality, and in the process, get washed up by the powerful ripples, while others ride profit waves all the way to the shoreline. The dilemma then is to determine how the markets are moving, and to what modes can they possibly change.
A single stock is many times affected by a few major headlines a year. However, the stock becomes a product of other equity movements through its beta exposure and can thus undergo many unexplainable swings in a year. These swings are not merely noise, but rather indication. They are telling us of market positioning, sentiment, and more importantly, the understanding that other investors have of the investing environment. It is therefore crucial to decipher such coded messages. To begin understanding what these signals can possibly mean, we begin first by looking at "normal" directional behavior in the financial markets.
In general, as equity markets rally, there is more inflow into stocks and away from bonds. This leads to a fall in treasuries and a rise in bond yields. This in turn boosts the local currency, and many times it also lifts the correlated high-yielding carry trade crosses. Furthermore, if the local currency is commodity-dependent, that is, the currency is used for transactions in commodities, an increase in the value of that currency will lead to a fall in the value of that commodity (i.e. USD and Crude Oil). All other trade-able financial securities, are usually derivative instruments of these primary risks and have either a leveraged or muted reaction to such price movements.
This is what SHOULD happen, but in reality, it happens only under particular circumstances. When the economy is robust, when there is political stability, and when investors and consumers are both becoming less risk averse, the above noted traits generally tend to apply. For instance, the U.S. economy from the post-dot com burst until the end of the Fed tightening cycle, generally experienced these types of correlated price movements. However, the scenario quickly began to change in early 2007.
After the first large retracement in the Shanghai Composite in February of 2007, the markets began losing this rational train of thought. Instead, what we began to see was a decoupling of such sensible price action that led to some serious consequences. The first hint that things were not of the norm came when a sustained de-correlation of gasoline and crude oil prices began to be noted in the 1st quarter. As crude oil inventories fell short of demand, crude prices pushed higher, but the prices at the pump remained relatively stable. The second display of such divergence came in late August. U.S. equities no longer rallied on the back of stronger financial data. Instead, after the surprise 50 b.p. rate cut by the Fed, the markets rallied on the back of weaker financial data in the hopes that there would be more rate cuts. This led to an "artificial" recovery in the markets that pushed the Dow Jones Industrial Average above 14,000 within 3 weeks of the summer's disaster; something was obviously wrong with the picture. The markets were moving completely out of sync; the Dollar in particular was in a downward spiral. The markets legitimization of such action was that, "if economic data is disappointing, then the Fed will cut rates, so the Dollar should fall. If the data is great, then its probably inflationary, but the Fed will then have to possibly deal with stagflation, so we should still sell the Dollar." This was a lose-lose situation for Dollar denominated securities.
And most of this price action was out of fear, completely illegitimate, and extremely over-extended. The markets had changed their behavioral pattern, and had taken on a new image, one ready to move quickly for the exit should something not feel right; the game was no longer about reason, but about gut, and about speculating on the role of the government. To this moment, much of this fear has not subsided, and as a result, much volatility has come back into the markets. But what we have ahead could lead us back to a path of reason.
Should a federal program be adopted to aid the subprime and bad-credit debtor, then the Federal Reserve may not have to succumb to the demand of the equity markets. Additionally, the month of January should prove to be positive for a beaten-down Dollar as continued repatriation flows from late December re-balancing of portfolios will create demand for the greenback.
So the question is not IF the markets will recourse to a rational state of behavior, but when. If all of the hints in the market are properly analyzed, a clear shift in market behavior can be denoted. Effectively harnessing that shift is what will ultimately make the difference between you becoming a millionaire or going broke. Good luck!
- Vishal Shah
