In light of the appalling events of last week it is instructive to look at the markets reaction to such news and to see what can be learnt about the psychology of markets. In analysing what went on in the least two days of the week it is necessary to set aside ones emotions about the terrible loss of life and look solely at the markets reaction and to try and work out why it behaved the way it did and what this might mean for our trading.
I want to begin with a simple observation, markets at present are boring from the perspective of event driven price moves. US markets have been relentlessly moving to new highs and very little is dissuading them from that course. In my mind this establishes a backdrop of lethargy where volatility is craved for. This can be seen in the continual calls for a correction/crash that come from all the bears who happen to have completely missed the five year swing up in the market. Many market participants, particularly talking heads cannot get their brains around the fact that the US market has just been marching on and it has done so in a relatively low volatility environment. In part they confuse volatility with trend, a mistake most make. Hoever, it is the paralysingly short attention span of market pundits that cause them to believe that something must happen to drive markets one way or another. The simple refrain that markets go up and markets go down is too subtle for them to understand.
If we look at a chart of the Dow, we can see the spike down that market had with news of the downing of MH17. In some quarters this event was being treated as being akin to the sinking of the Luisitania in 1915 which was one of the defining events of the First World War and which began the long road towards US involvement in the conflict. Note the market doesn’t think so because it immediately recovered.
As you can see price slipped to both mid term and short term support and then recovered. By the open on Friday the hysteria had slipped out of the market and price bounced.
The reason this event was not as detrimental to markets can be seen in the following charts.
Within markets there are two barometer commodities that move in concert with political crisis’s – they are crude oil and gold. Gold simply because it is a safe haven and crude because it is inextricably linked to the emotions of traders. The basic mantra is – something bad happens these two go up. Whilst, I claim no great geopolitical insights or knowledge it would seem obvious to me that if the world were moving to a much wider conflict as opposed to a shocking local tragedy then these two instruments would have moved sharply.
What we do see is a market where volatility is still below its long term average and had barely spiked as seem below.
This raises the question of the hysterics that surround a relative versus absolute move. The Dows reaction in absolute terms seemed large but in relative terms is actually quite modest. Consider the chart below on which I have plotted 1% moves on the Dow. The chart however comes with a caveat – the indicator used is called Zig Zag and it cannot be used for new moves because of its doubtful validity. This problem occurs because of the setting of a threshold value – in this case 1%. If a move does not continue then the current move will disappear and the previous trend appear to be uninterputed.
The Dow has in the past few months had a multiple moves of 1% or more – absolute and relative are two different things to traders.
The lessons to be learnt in event driven markets are I feel very simple. Firslty, you need to ask yourself a strategic question. Has anything occurred that changes your fundamental approach in th market at present? If not then there is no need to take any action. If yes then you default to what your plan is for a significant trend change. The second question is one of trade management or is tactical in nature. Have you been tipped out of any trades by the event? If you have what are your plans for re-entering the trade?
As a personal dislaimer I remain long the Dow because nothing has happened either strategically or tactially to move me from that course.