Markets are not rational – but we are

Markets are not rational – but we are

Long time readers of mine will know that the ‘fundamentals’ do not drive the market.  It is purely aggregate sentiment that moves it.  Yes, a ‘shock’ report may give it a kick (such as the Brexit hit to sterling), but markets move in waves that are regulated by the Wave Principle that the Elliott wave theory so ably describes (and forecasts).

Currently, we have several examples of ‘irrational’ markets, where the fundamentals are completely mis-aligned with market action; the most egregious being US stock markets.  While earnings are trending down, stocks are in a near-vertical rally.  That is not supposed to happen.

But there is another market where market action is defying the fundamentals – iron ore.  I have mentioned this market before and noted it is in a strong rally phase.  But supplies are abundant everywhere, stockpiles are growing and China’s steel production is widely forecast to contract.

Here is a Bloomberg article that sums up the vigorous head scratching going on among very clever economists employed by banks, mining companies and hedge funds.  These guys are paid big bucks (and is yet another case of rewards for failure) to forecast price action.  Iron ore is in a vigorous bull phase.

In fact, Goldman Sachs is predicting a drop in price to $40 in Q4, and Morgan Stanley says $35 is on the cards.

But hold on – weren’t this latter pair of PhD economist-laden banks forecasting gold would drop to below $1,000 last December?  And I recall they were predicting the euro would drop to below dollar parity last year?  Hmm.  Seems that when they open their mouths, canny traders should trade against them.

They are wrong because they cling to the erroneous belief that financial markets are rational.  If they had even a passing knowledge of Elliott wave theory, they would reach a different oonclusion. Here is the iron ore chart

The low was made in December as commodities of all kinds ended their big slide.  And from that low, we have an absolute textbook example of a five impulsive waves up.  It satisfies all of Elliott’s rules and guidelines and when the top was put in in April, you could have made a confident forecast that the next move would very likely be a corrective down move in an A-B-C form.

But of course, most pundits were forecasting even higher prices because like most people, they become more bullish as prices rise.  That is what drives bullish sentiment data to extremes at major tops – and is a major tip-off for me to expect a severe correction.

And that A-B-C correction was provided as if by magic.  And now, the market is following the roadmap as laid down by the EWT – it is continuing its rally after completing the A-B-C correction.  In fact, the rally since early June has produced a stunning gain of 33%.

So how do the fundamentalists explain this picture?  Of course, they can’t.

How can a serious analyst/trader live with him/herself when they stick to the old paradigm that the fundamentals and news drives the market – knowing that it is giving the completely wrong answer?  Because that’s what sells newspapers, of course!  Most traders/investors believe that if they follow enough news they will become great traders.  All they need is an edge and a piece of information hidden from most.  Wrong!

In fact, all they need is to be able to count to five.  Most of us can do that, even PhD economists.

But I am very pleased few traders understand how markets really work.  It means that those of us that do, are provided with myriad great trading opportunities thrown up by the herding news-followers.

Many traders have a successful career in the ‘real’ world where there is a logical progression to success.  For instance, to become a doctor, many years of study are required – and this course of study has been followed by many others.  The path is clear cut.  Follow it and you stand a good chance of being a good doctor able to solve medical problems.

But not so in the world of financial markets!  When an intelligent person decides to become a trader/investor, they quickly discover that the rules are very different – in fact, they can be the very opposite of those that enable you to navigate everyday challenges.

And that is because most start with the same cause-effect paradigm.  If a bullish news item appears, logic says the price should rise. That is our natural first reaction. But often, the price falls instead in a seemingly perverse way.  How does that fit into the cause-effect model?  Of course, it doesn’t.

And in a nutshell, that is why PhD economists and their ilk get it so wrong so often.

But we can use this tendency to our advantage!  While they are buying, we can be selling.

My early years were taken up with the study of physics and mathematics – two of the most conforming cause-and-effect fields.  Remember Newton’s Laws of Motion? For every force, there is an equal and opposite one.  No exceptions. That is cause-and-effect in spades!

Transfer that mind-set into the markets and you will soon discover, as I did, that markets are definitely not physical systems that always obey the same fixed laws.  It took me a while to understand that.


Carney chickens out

So no interest rate change from the BoE today, despite a common belief they would, especially after official heavy hints.  My reading is that they were frightened off because they sensed a reduction in the rate would weaken sterling even more – and play havoc with their fancy forecasts – and provoke angry phone calls from the eurozone complaining our cheaper pound would hurt their exports.

Maybe Carney did a deal with Draghi in a quid pro quo of some sort.

Naturally, heavy short covering ensued. In a stunning example of being whipsawed, I wonder if these recent shorts were the same traders who were long on June 22 at the 1.50 level just prior to the Brexit vote result. Hmm.

But this trade is a great example of how I use the Break Even Rule.

We actually shorted GBP/USD this week on the rally to the Fibonacci 23% level at 1.33

Yesterday, the market dropped to 1.31 and allowed me to move my PS to break even.

And today on the short covering rally, my stop was hit at 1.33 to take me out with zero loss.  Now the market is backing off from the initial spike to above 1.34 and I am free to sit back and watch with no damage ot my account.

Meanwhile, one of my Trades for 2016 – long USD/JPY – is powering ahead nicely.

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