What constitutes a Gestalt Shift? Events that cause a Gestalt shift must create a fundamental change in the psychology of the market regarding the participants current focus or their perception of the current macro-environment. It musnt always a surprise, but it must be big enough (in terms of significance) to result in a change in direction of investment flows (not just an illiquid countertrend move). The types of drivers at any one time in the market could include (but are not limited to) at least one of the following:

- expectations of interest rate differentials
-geopolitical developments
-trade/current account deficits
-relative attractiveness/repulsiveness to business and investment (i.e. beauty contest)
-economic health problems and crises
-perception of risk (usually associated with carry trades, low grade bonds, and emerging market equities).
-correlations (equities, commodities, recoupling vs. decoupling story)

The focus of institutional players (and often central banks) who are moving the market over time may rotate among the above categories through time due to different events or accumulations of events that cause a Gestalt Shift.

An example of a Gestalt shift in recent memory is the movement of capital flows into the US in 2005 after a multiyear fall in value of the dollar. The Euro had had a long run up and appeared overvalued at the time. Consequently, traders started looking for indications of a shift. 2005 marked the beginning of a temporary reduction in the US current account deficit (aided by dollar repatriation from tax breaks), continued rate hikes to fight inflation in the states, and deteriorating Eurozone economic activity and constitutional issues causing internal political instability. In short, it was no single event that caused a shift in money flow, but rather a shift in focus to rewarding the dollar for getting its act together whereas the Euro was getting into trouble. Obviously this shift was only temporary in the context of big picture fundamentals, as the deficit narrowed but didnt disappear, and the ECB soon needed to step in and fight inflation itself. The concept to take away from this is that it was a shift in PERCEPTION on one time scale versus another. Due to the human element of the market, the market doesnt always move on solid fundamentals.

The lesson: The markets focus will shift. Make sure to know what is in focus and what could potentially come into focus (to be one step ahead). By knowing the focus you now have a frame, or context within which the significance of daily/weekly events and price movements can be evaluated. Something that seems out of context could depict an opportunity (remember, a subplot in the soap opera). You MUST get into the minds of the traders and know not only their opinion, but what the opinion could possibly shift to, and how much of that has been priced in! Granted this is impossible to do precisely, it is nevertheless an edge which we apply together with our other edges of low leverage and time and price diversification.

In contrast to the above example, what we are seeing today (August 2008) is a reverse-beauty contest in which the focus is on which economy appears the least ugly. The focus shifted from inflation fighting and relative lack of credit risk in the Eurozone compared to in the US, to a concept that horrible US economic conditions were already priced into the dollar but not yet other currencies. This is indeed a Gestalt shift, although it must be viewed in the context of the bigger picture fundamentals which show a weak dollar over the long term. Eventually, the market will realize a new shift that will return the focus to the big picture.