Déjà Vu Disarray

Where self contained news FITS in history

As the G7 meeting ends in disarray we are left with a strong sense of déjà vu. Canadian PM Trudeau’s announcement to impose retaliatory tariffs on July 1 has a familiar ring. It was Canada that led global opposition to US tariff proposals in the run up to the 1929 crash. Similarly, in 1987 a series of unresolved international trade spats continually eroded the foundations of an overvalued global stock market. Given the similarity of so many fundamental inter-market, technical and sentiment (FITS) conditions of 1929 and 1987 and 2018, it is hard not to believe the analogous break down in international relations will not play a key role in the timing of a similar stock market fall out later this year.

But when?

In last week’s newsletter we explained why such news can have a variable impact on the markets. Both the underlying FITS condition of a market and the nature of the news itself can vary. This week we look at how the interaction of those FITS conditions produce predictable outcomes over the course of relatively self contained news events or releases.

As the uncertainty of President Trump’s meeting with North Korean’s Kim promises to limit the fall out of an indecisive G7 meeting, an understanding of how news and its impact on markets typically develops over the cycle can provide real insight into how and when it will be resolved.

At the end of this week, we would like to think the news and the market’s interpretation will be clearer. But we doubt it will be. However that does not detract from an increasingly clear prognosis. The underlying conditions and the ‘news’ are together taking the market closer to an inevitable outcome.

Surprising though it may seem The Crash of 2018 will itself be a relatively self contained news event. Next week’s newsletter will explain how news and it’s impact develops over the cycle and how this helps and hopefully will help us time the event of 2018.

Many of you will be familiar with our release fractals, which cover nearly every major economic release and now earnings too. They can work spectacularly well.

But even when they don’t play out perfectly, they still provide us with a guide going into each release. As we shall see, trading news is not about guessing the headline number correctly and catching a lucky trade, but using probabilities and being able to define an edge, even if this is just a general bias.

Thankfully we can get more specific. Firstly we can separate each release and find a bias both before and after the report.

We can take this several steps further. In their simplest form the outcome of releases are binary; earnings can either beat or miss, NFP can either beat or miss. As they are scheduled for a specific time, the market makes every effort to anticipate and position for what it see as the most likely outcome.

Of course we do not have a crystal ball which can tell us news before it happens. But what if we did? Would it allow us to predict the price reaction? If we knew the NFP figure was going to be miss at 150k would we immediately take out a short on the S&P500? No way.

This isn’t to say the fundamental side of the release is not important, but it needs to be taken in context, not in isolation. For one we need to understand the broader narrative. Is a cooling NFP actually good news as it will keep rates and the Fed at bay? Secondly, we need to relate it to the market’s expectation, positioning and sentiment going into the release as these will have a large effect on the movement when the numbers hit. While there are various ways to do this, we believe the best approach is to analyze the price action as the manner in which price moves reflects all the above variables.

It should be understood that the way price moves ahead of a release does not necessarily predict the outcome of the release. The market has no more a crystal ball than we do, but it is very effective at anticipating and positioning for the next move. This gives us an edge or a bias, both in price movement and timing.

Let us take an example.

We produced the above fractal last week, on the Wednesday before NFP on June 1st. Gold was rallying and some participants may have been tempted to buy for a potential rally. However, our fractal told us gold typically makes a move lower in the days leading up to NFP and then recovers the following week. Importantly it doesn’t really matter if NFP beats or misses; we are only interested in an edge and we can see from the above our edge comes post release. From a slightly longer term perspective, if we were already long and had concerns about a spike down, the fractal would help us stay the course.

One further consideration is how different markets behave under various conditions. Our release fractals are not generic. They factor in that different markets have different participants and drivers and these give them unique characters. Take reactions to Netflix (NFLX) and Facebook (FB) earnings, for example. Both show a positive bias going into the release, and an earnings beat ignites large rallies as you may expect. However, Facebook often fades significantly post earnings, while Netflix also fades but holds the gap and usually continues strongly higher.

Of course there are no absolutes, but this gives us a guide to tradeable opportunities. If we happen to miss the earnings move in Netflix, we know there are good probabilities to buy the pullback in the next sessions for continuation of the rally. This is not true of Facebook.

Taking it a step further, we don’t even need to take the risk of holding through Netflix earnings (though this approach could miss a big rally). Buying ahead of earnings has an incredible strike rate with six of the last seven earnings dates seeing showing strong rallies into the release.

Facebook also has a reliable pattern. Once the earnings move fades and short term profit taking pushes price down over the next month or so, it’s already time to think about buying for the next lead in rally.

In all honesty I used to hate earnings and economic releases as they always seemed like a coin flip. I still wouldn’t open large positions ahead of a release, but I am much more comfortable holding through a release and I can make plans based on firm expectations and probabilities.

When trading news, knowing our edge is perhaps the best we can hope for. Trying to predict whether a release will beat or miss can actually get in the way of a profitable trade; would you rather be right or make money?

There is much more to be said about not just fractals, but how fractals help us trade news. Black swans have quite consistent effects on markets, as do Trump tweets, and tariff announcements, We will cover these at another time, but for now, we will leave you with …

Here’s to making the very best. Good Luck and Good Trading

Ed Matts and Andrew McElroy

To receive our weekly articles by email in advance of publication, please sign up for our Sunday newsletter.