FX Weekly - Reality Bites 11/7-14/08

November 8, 2008

bkpicsmall

————–Top 5 Stories in FX This Week—————-

It is all About the Transmission
Are U.S. Automakers Running Out of Time — and Options
The Great Untangling
Reassessment of Every Asset Everywhere
Genuis Fails Again

—————–In Sync—————

The divide between blue and red states in America reminds me of the differences between technicians and fundamentalists in the market. And although I come from the bluest zip code, of the bluest Congressional district, of the bluest state in the nation I have long ago recognized that our most successful politicians in the post WW2 period (Reagan, Clinton, Obama) have been able to appeal to both sides of the aisle while our worst (Nixon, Carter,W Bush) have been horrid partisan hacks that damaged the country for years to come.

Is there a lesson for traders in American politics? I believe there is. Just as good politicians are able to combine the best ideas of market principles and social justice for a better society, so too the most successful traders are able to synthesize the fundamentals and technicals to create consistently profitable positions.

————–FX Market Outlook————–

First year economics students learn that the most primitive model of economic activity is nothing more than just a construct of self fulfilling expectations. Consumers feel good. They spend money. In response businesses produce more goods and services, hire more workers, who in turn buy even more goods and services and the GDP grows. On the flip side, consumers feel bad. They retrench. Businesses cut back, fire workers and final demand plummets as a result and GDP contracts.

The longer I live the more I am amazed at how accurately this ridiculously simple model reflects the reality of market economy. Forget econometrics, forget multi-variate formulas. To understand economic reality all you need to do is understand this model. Of course as I write this piece reality bites. ISM data this week printed to 38.9 -its worst reading since 1982. Unemployment hit a 14 year high at 6.5% and US automakers look like the next sector to go belly up. Even the mighty Toyota hinted that it may actually book a loss in the second half of the year. Welcome to the vicious cycle.

How bad will it get? No one knows. One thing however, seems reasonably certain. The economic situation in US is likely to get worse before it gets batter. Too much wealth has disappeared into very stupid investments in real estate and supply is still coming online. New York is still littered with hundreds of half built skyscrapers (three on my street alone) that will hit the market next year. Who will pay $1M for a 600 square foot studio in Manhattan?

How about Dubai? Same thing. Across the globe housing prices do not reflect building costs. You cannot expect to sell a unit for $500K than only costs you $125k to build. Those type of gargantuan profit margins never, ever last in the marketplace for long. Once housing becomes unaffordable for the majority of the population it ceases to have value. The pain we see now is simply this adjustment process unfolding in front of our eyes.

In order for true wealth re-building to occur housing must follow the price path of all other goods in our economy such as computers where every year we get more value for less money. Alas not so with housing. We now get sheet rock prefab boxes that crumble at the first sign of wind for far higher prices than our parents ever did. But fear not, like always our civilization will no doubt be saved by technology, as green, energy efficient, more durable edifices are built in the future. For now however we are in quagmire and the rebound may be a long way off.

The net impact on the market of this downbeat reality is likely to be mind numbingly boring range as we work off the excesses of the past few years. Although volatility remains the staple of the intra-day price action in the currency market it will not last. We know that volatility is much more mean reverting than price and already see some signs of moderation in the daily ranges. For FX traders currently counting on endless days of 500 point moves in the pound - don’t hold you breath. We may have a few more weeks of this environment, but then the price action may slow to crawl as markets react to the grinding slow pace of adjustment in the real economy.

————–Top 5 Stories in FX This Week—————-

It is all About the Transmission
Are U.S. Automakers Running Out of Time — and Options
The Great Untangling
Reassessment of Every Asset Everywhere
Genuis Fails Again

—————–In Sync—————

For a guy who wrote a book in Technical Analysis in the Currency Market, no one has been more contemptuous of technicals in trading. Technicals after all tell you the past, not the future. My eyes would roll over every time I would hear some technical guru pompously proclaim that XXX was support in a certain currency and if XXX was broken then a massive move would be sure to follow. The history of technical analysis is littered with countless examples of broken support or failed breakouts that go nowhere. The whole process reminds more of reading of entrails and voodoo dolls rather than serious scientific inquiry and analysis.

After all it is newflow that moves price action, so only fundamentals matter in the currency market -right?

Eh, actually no.

News by itself moves nothing. It is the traders reaction to the news that drives prices, not the news itself. Speculative trading is all about understanding market sentiment. It’s all about feeling not reason. That’s why engineers and Phd mathematicians often fail miserably at it, losing out to semi literate high school drop outs who have much higher emotional IQs.

So while fundamentals may be the catalyst for sentiment, technicals play a critical role by providing CONTEXT. It the price action does not confirm your analysis then the analysis is worthless for the moment. The currency market graveyard is full of corpses of failed fundamenatlists who were correct in their thesis but wrong on their timing. The key to making money in trading is to be in sync both fundamentally and technically.

Here is this video to show you in more detail what I mean.