the gestalt shift

The market is being optimistic again- how should you trade it?

All currencies except for the Yen have been moving up against the dollar. This classic signature of risk-taking sentiment is reflected by traders’ attention to news events which are indicating the possibility of an economic recovery. What’s happening here is a “confirmational” behavioral bias. This is the tendency for people to filter out facts from an incoming stream of information that don’t agree with what they want to believe and to focus on facts that confirm their pre-conceived notions. To be more specific, the market started to become immune to bad news over the course of time, and then developed this notion that the worst of the crisis is over. It didn’t take long for the market to find “confirming evidence” to prove this assertion. A good indication of sentiment is found in the media: the Financial Times publishes a headline with: “Glimmers of Hope for the US Economy,” and the Wall Street Journal remarks, “Investors See Silver Lining.” However, there are still companies failing, poor employment, a recent -6.1% plunge in quarterly GDP, and problems with personal unsecured debt. The problem is not over yet.

What I would like to convey is that this optimism is fragile and there are still risks to the downside. As you may know, I don’t claim to predict anything, and successful trading is about forming “IF-THEN” statements, not making “UP/DOWN this week” statements. We can say whether the dollar will strengthen or weaken based on considering what the current factors are. Here are the things arguing against dollar strength:

1. A tremendous amount of inflation generated from stimulus packages, etc.
2. The dollar strengthened too quickly on risk aversion and the worst of the global crisis *may* be over

Here are the factors for dollar strength:

1. Any risky events or information entering the market will lead to dollar buying because the US is still considered to be a harbor for safe haven assets.
2. The US has recovered the swiftest from past global recessions so money could flow into US equities and prop up the dollar initially.

The IF-THEN statement for trading is the following:

IF a catalyst happens that absolutely convinces the market that global growth has recovered THEN start buying Euros and other currencies. This could be a surprise, dramatic increase in the non-farm payrolls value on Friday, or a sharp increase in Pending Home Sales. Granted this is still a confirmation bias, but it will be supported by more significant evidence and the market will definitely lend credence to it, perpetuating the increase in positive sentiment.

On the flip side, IF no significant fundamental information enters the market in the mean time, THEN short the Euro above 1.30 and buy it below. The Euro should continue to anchor 1.30 until it finds a fundamental reason to go higher. Just remember not to extrapolate any movement in one direction or the other as the start of a new trend, because the market has a low signal-to-noise ratio.

I would like to caution using this analysis, because things could change very quickly. Points 1 and 2 regarding weakening of the US Dollar could very well come through sooner than expected. In fact, we are already seeing signs that the market is losing correlations with equities and ceasing to respond to certain news events that were previously important. This dynamic often suggests that a trend may be forming (weaker USD), so consider that to be a possibility in the medium term and keep leverage low.

Monday, May 4th, 2009, by admin and is filed under "Behavior, Inefficiencies, Market dynamics, Strategy, Uncategorized, confirmation bias ". You can leave a response here, or send a Trackback from your own site.