Markets return to normal – but what’s normal?

bigstock_Men_Around_Question_1831261With the US government shut down at an end and the debt ceiling crisis kicked into the long grass, at least for the time being, market players can now return to the usual giddy round of fundamental news releases and economic data.

The most anticipated of these was this week’s much delayed non farm payroll data, which contrary to market expectation delivered a very, very poor number, coming in at 148k against a forecast of 180k. The number was accompanied by the usual better than expected unemployment rate of 7.2% – which is completely meaningless and is only decreasing as more and more of the unemployed either give up looking for work or fall out of the statistics completely. However, what the payroll data did reveal, once again, is that the all important participation rate remains stuck at 63.2%.

And with this number at a 35 year low the FED’s room for manoeuvre with regard its bond buying program is becoming ever narrower, and for the time being taper talk, is therefore just that – talk.

Market reaction to these numbers was fairly predictable: there was a further sell off in the US dollar and equities moved higher, with a particularly strong performance from the S&P500 which posted new highs, and is now looking to push onto 1800. In fact the S&P is up over 20% since the beginning of this year, and on course for its best annual performance since the late 1990s.

The S&P is also a clear example of how money printing has been great for asset prices, but not so great for the broader economy, and this divergence between equity markets and the underlying performance of the US economy – as seen in the payroll data – is likely to intensify, not least because equity bulls now have time on their side as the FED is forced to continue with its QE program in its battle to spark some life into the real economy.

The current disconnect between equity markets and economic reality is something we simply have to accept, and is the result of the FED’s QE program creating asset bubbles. In many ways it is also an example of one of the many skills we have to develop as traders, and is what I can only describe as tolerating a degree of cognitive dissonance.

For those of you unfamiliar with this term – cognitive dissonance can best be described as holding two (or more) conflicting ideas or beliefs simultaneously. In our case we simply accept the paradox of rising equities in a poorly performing economy, and trade accordingly. In other words trade what we see and not what we believe should be.

In my webinars I often explain how cognitive dissonance can benefit new traders looking to trade short time frames which are often running counter to the trend in a higher time frame. In forex, for example the 5 min chart for a particular pair could show a perfectly valid set up to the long side, but which is simply a pullback on a higher time frame where the pair is overall bearish.

Therefore, in deciding to take the trade to the long side we not only accept this disharmony in the overall trend, but we also accept that the risk on this trade is going to be higher – because we are going counter to the bearish bias. We also know we are not likely to be in the trade for very long.

What I also stress in my webinars is that there are only two risks in trading. The first is the financial risk, which is easy to assess and is covered by our money management rules, and is simply the amount of money we are prepared to risk on a trade.

The second risk is the risk on the trade itself, which is far more difficult to assess and quantify. However, by using multiple timeframes – at least two, if not three, will help to reduce and quantify this risk. Of course, deciding which timeframes to use will depend on an individual trader’s trading horizon. So, for example, a swing trader looking to hold positions for a matter of days could use the daily, four hour & 1 hour chart, whereas an intra day scalping trader could be using either tick or time charts set at 1, 5 and 15m. In both examples the daily or 15 min chart would act as the benchmark, or anchor chart – and would confirm the bias for the instrument, as well as revealing whether any trade taken in the lower timeframes would be with the trend or against it.

This assessment alone will not only determine the degree of risk on the trade but also the likely duration of the trade, which would be revealed by the price action, volume, price pattern and areas of support and resistance.

However, returning to the S&P500, since its surge following the NFP data, it has, not surprisingly, pulled back on a mixture of mixed earnings, the Eurozone bank stress tests, and Chinese policy risk. The last of these is a bit of mystery, but whenever there is a pullback in the markets, we can be sure there is always a reference to some aspect of the Chinese economy which is to blame. And indeed whilst writing this post, the S&P has in fact recovered, allegedly on better than expected Chinese data. So, China’s role in the markets is either as a hero or villain. No shades of grey here!

However, from a technical perspective it is clearly evident that the S&P is now attacking fresh highs, and whenever this happens in any instrument or market trading nerves can become jangled and somewhat frayed, and all we can do is monitor the chart and keep a close eye on those market internals, such as the VIX to help us assess overall market sentiment and mood. The VIX is, of course, inversely correlated with equities, so that as it falls, equities will rise and is a great chart to practice cognitive dissonance. The VIX is also one of those benchmark charts that all traders and investors should have on their screens at all times, as it measures on a tick by tick basis the prevailing mood and bias of the market.

From a technical perspective there are some key price levels on the VIX which are proving to be highly significant. The downside number to watch is 12.30, and represents a deep area of price support through which the index has not been able, so far, to push through. In fact it has been oscillating between this lower level and up towards 21.50 for most of the year, representing ebb and flow of risk in the market. Indeed the price action can best be described as catenary. The key for equities in the medium term is to see the VIX break this platform of support and move into single figures which would then propel markets into new high ground. Once in single figures then the old adage of ‘when the VIX is low, it’s time to go’ may indeed herald the start of a major reversal in risk assets, such as equities.

Meanwhile, the daily chart of the ES (which is the e-mini future for the S&P500) is naturally at the other end of the scale as the index has been moving firmly beyond 1700 and on towards 1750. However, for volume and price aficionados, it is particularly noteworthy that this recent bullish surge higher has been accompanied by declining volumes, suggesting at the very least a pause point at the 1750 price point, as market players become increasingly nervous. What is clear perhaps, is that the disconect is set to continue for some time to come, and for traders, the motto is simple. Trade what you see, and not what you want to see. In other words, leave your opinions on the front step!

By Anna Coulling

About Anna 1007 Articles
Hi – my name is Anna Coulling and I am a full time currency, commodities and equities trader. I have been involved in both trading and investing for over fifteen years and have traded many different financial instruments, from options and futures to stocks and commodities. I write and publish articles ( mostly for free ) for UK and international publications on a wide variety of financial issues, and in particular I enjoy helping others learn how to invest and trade.

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