Kris has asked me (Murray Dawes) to take the helm of Money Morning every Wednesday from now on.
Each week I’ll focus my effort on giving you an insight into my technical and fundamental methods for analysing markets, as well as discussing market related current events that you won’t read about in the mainstream media.
But let’s be honest, understanding the current state of markets world-wide isn’t easy. The flood of information you’re bombarded with can be overwhelming. And it’s not always easy to figure out what goes where.
Putting together the pieces of the jigsaw is one thing, using it to make you money consistently over time and in any market condition is quite another.
But that’s exactly what I’ll try to help you do using my technical and fundamental market insight…
So, just how do I approach the market?
My approach to the task of making money in financial markets is to build an overriding long term view of the markets (macroeconomic) and then drill down to specific sectors and companies (microeconomic).
From there I form a bullish or bearish view on each sector of the economy and then use technical analysis to find good risk/reward entry points into particular stocks. It’s not rocket science, but it does take patience and attention to detail.
I like to trade the stock market both long (‘long’ is when you buy stocks betting they will go up in price) and short (the term ‘short’ creates lots of confusion; think of it as a bet that prices will go down).
Trading long and short creates a number of benefits for traders.
For instance, by trading the market both long and short you can manage the market exposure and risk to a far greater degree than if you only traded stocks from the long side. For example you can create what is known as a market neutral position by buying some stocks while short selling others.
If you do this it should lower your overall market exposure to almost negligible levels, while still allowing you to make money as values shift between different stocks or sectors.
Short Selling Can Lower Your Risk
That said, most traders don’t short sell, because they think it’s high risk. But the fact is that when managed properly, shorting stocks or indices can lower the overall volatility of your portfolio while also giving you access to large returns when markets sell-off sharply.
Ultimately my method is a technical one based on chart patterns and probabilities. But unusually for a technical trader, the overall bias in my trading is formed by a fundamental view.
In fact I would say that the relationship between fundamentals and technicals is mutually beneficial. They need each other and are more valuable together than separately.
I say that because when investing there’s every chance your fundamental view can be proven wrong for a long period of time. In that case I believe it’s important for you to have a technical filter that overrides your fundamental view and stops you from fighting the current state of the market.
This approach can keep mistakes to a minimum.
But technical trading isn’t just about lines on a chart. You should also see it as a risk management tool. As a trader you should want to know quickly if you’ve got the trade wrong.
But if you’re a purely fundamental investor or trader, there are no hard and fast rules to know when you’re wrong. If you bought a stock on a fundamental view and you’ve lost 30% after a year of holding the stock are you wrong? If not, then when are you wrong?
What percentage of the stock’s price should you risk on a fundamental view? 20, 30, 60, 100%?
With a technical approach it’s much easier to create rules that let will let you know very quickly if you’re wrong. And the best thing is, you can make the rules concrete so you’re not left in no man’s land wondering whether to hold on or sell.
Trading is Mental
If you’ve done any trading in the past then I’m sure you understand just how mentally draining it can be. The more clinical and defined your trading rules are, the lower the chances are that you’ll have to make big decisions under pressure.
Because the fact is that when you’re forced to make important decisions under pressure in trading, you may end up making the wrong decision…such as holding losers or taking profits too early on winners.
Therefore using a technical approach in trading can inform the decision making process and lower stress levels when you stick to clearly defined rules.
So, that’s the theory, but how does it work in practice? Let me give you an example…
Here’s a rundown of the current state of the markets and how I see things panning out over the coming weeks.
S+P 500 Daily Chart
If possible you should click on the chart above so it opens as a larger image. That way you can follow along with my reasoning.
You should know that the European Central Bank (ECB) and the US Fed have recently embarked on the ‘kitchen sink’ strategy. That is, they’re throwing everything at their economies to try and get them moving. That includes printing an unlimited amount of money for as long as both central banks believe necessary.
As you can see on the chart, it’s quite clear that QE1, QE2, Operation Twist and the LTRO facility in Europe (all forms of money printing) managed to inspire strong rallies over the last few years. If they’re going to keep expanding their balance sheets into the future then it’s reasonable to think that equity markets could keep rallying purely on the back of money printing.
But the fundamental picture is currently saying the exact opposite.
80% of the world’s manufacturing is currently in contraction. China, Europe and the US are all slowing to the point where some say that Europe and the US are already in or close to a recession.
But the market is fixated on the view that the worse things get the more money will be printed, and that will be good for stocks. In short: good news is good news but bad news is better!
This disconnection between economic fundamentals and market pricing based on central bank intervention creates a very high risk brew. If you’re going to buy the stock market due to the money printing you had better make sure your timing is right.
Now look at the S+P 500 chart again. You’ll see that over the past couple of years every time the stock market has broken out to new highs after a correction we’ve seen a short sharp rally, which has ultimately proven to be the high of the move.
The following few months after the breakout then saw the market plunge dramatically. I have a special term for this type of price action. When the initial breakout creates a new high, I call it a ‘false breakout’. That’s because it did breakout above the previous high but buying that breakout proved to be the wrong thing to do.
Now look at where we are currently. The rally after the announcement of QE3 has caused a similar breakout to new highs. Based on everything I’ve just said, would you think that buying now was a low risk trade or a high risk one?
From where I sit, if the market fails to hold these levels and sells off to a level below the previous high of 1422 made in April this year, then there’s a high chance that we’ll see a sharp correction back towards the 200 day moving average at 1350.
So if you bought the market today I could almost guarantee that you will have been spooked out of your position by the time that happens.
But if it’s not the time to buy, does it mean it’s time to short sell the market today? If only it was that simple, because the answer is no.
If you look at the chart again you’ll see that the 10-day moving average (blue line) is above the 35 day moving average (red line) which in turn is above the 200 day moving average (black line).
This means the market is in both intermediate and long term uptrend according to my definitions of trends (I’ll explain these terms more in the coming weeks). At the very least I need to see the 10-day moving average close below the 35-day moving average before I can become bearish.
All up, the current state of the market is sending conflicting technical signals and when there are conflicting signals it’s usually much better to wait and watch than to trade aggressively.
Soon enough the stars will align and they will either confirm that the current breakout is real and worth jumping on to, or they will show the current move is a ‘false break’ which will have wrong footed the market after the QE3 announcement.
My view is that it’s the latter.
By using technical analysis I now have some clear levels which will inform my trading decisions, and the filters I use have stopped me from trading against the trend for the past couple of months.
One of my favourite quotes about technical trading is that ‘it’s a wind sock and not a crystal ball’. No one can know the future for sure, but you can use the past to guide you.
I look forward to writing each Wednesday and giving you some more insight into the world of technical analysis.
Murray Dawes
Editor, Slipstream Trader
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