Altering Currency: Trading Through Sentiment and Cynicism

Markets can and will go through phases and often these periods fit smartly inside a calendar.

2013 is remembered as the year equities rallied well before the data said so. With two months remaining, it appears 2014 will be memorialized as the year where sentiment trumped fundamentals; where whimsy punched far above its weight class, decisively knocking out the heavily favorite contenders with qualities like earnings growth, decent economic fundamentals and central bank accommodation.

Like an ocean fog bank, sentiment is not always transitory nor should it be taken lightly. Sentiment has taken down kings and kingdoms along with movie stars and markets.

October appeared to be the culmination of the entire year served on a silver platter. Whether we discuss equities, interest rates, metals, or grains, the year has been all about imposing the greatest pain on the maximum amount of people. In the past month alone, we observed an S&P 500 10% peak-to-trough correction, then an uninterrupted 9% S&P500 snap-back rally. As a result, major government bonds abruptly spiked, credit spreads widened, gold fell back to $1,200, and soybean meal jumped 35%!

However, three things stood out and brought back to mind what I’ve suspected has been going on under the covers for months.

First, the VIX, Wall Street’s so-called fear gauge, traded as high as 31 on October 15. I found this price level very difficult to comprehend as the VIX was actually trading higher on October 15 than during most of the 2012 Eurozone crisis, and equal to the price levels observed during the Japanese earthquake in 2011!  Are things today really that bad?

To further complicate matters, recall the moderately disappointing U.S. retail sales number on October 16and the subsequent 35 basis point drop in the US 10-Year Treasury Yield. Other than 2008-2009, you would need to return to the late 1980’s to find an intra-day move of this magnitude. Lastly, the agricultural complex and the uninterrupted $1.40 rally in soybeans and $0.55 in corn. These were supersized moves and ones likened to parched earth not indicative to minor tweaks in the narrative.

I maintain a trading journal and have so for 25 years – a “life-thickener” that has helped me pay closer attention to the things that upset markets. This journal has also been an exercise in discipline – helping me develop and winnow my core set of trading principles – the very foundation of my research, trading, and risk-management. Here are some of the things I’ve learned over the years.

• Above all else – preserve your principle!
• Its only money.
• Avoid major drawdowns – be willing to lose but avoid the big loss.
• Don’t worry about super-sized gains – worry more about consistency.

My trading technique is hard- centered on my viewpoint of how markets operate based entirely on the notion that markets are driven predominantly by human behavior (i.e. sentiment, psychology). Since markets are nothing more than an assembly of distinct decision makers dealing capital to investment strategies, by understanding how and when humans operate emotionally, I could then find market anomalies (e.g. Octobers outsized stock market decline) and subsequently profit from them.

An overriding, yet often overlooked, decisive factor of successful trading is the disciplined, relentless and ruthless focus on risk management and the safeguarding of capital. I can’t stress  enough how vital it is to insert (pre-trade) and take every single stop-loss or hedge with options – this will go a very long way toward maintaining a cool, calm mental approach over trading decisions along with deflecting the market noise that surrounds us. It’s been said that markets are larger than any one person and markets can trend much longer than most can remain solvent. The path to long-term success is to protect your profits (pre-trade) at all costs.

According to my journal of trading experience, market values have almost NEVER – on a short-term basis - been aligned with what the true fundamental, economic value, intrinsic value says it should be. My first chronicle entry dates back to the British Pound / US dollar futures markets in the early 1980’s. It started with “The British Pound simply cannot go 1-to-1 with the U.S. dollar,” and ends with the dramatic market moves that transpired this past month – with hundreds and hundreds of pages in-between.

Fundamental, statistical, and technical analysis aside, fear and greed will ultimately always drive prices to levels of excessive premiums or severe discounts and for extraordinary bits of time. The trader who can both revere sentiment yet, ultimately trade against it in a risk-adjusted manner will be very successful indeed.