The Battle of Emotional Intelligence

Knowing how to keep ahead of the market.

In a week shaped by President Trump’s weekend tweet confirming the imposition of higher tariffs, and the failure so far of trade talks to stop this, the markets are left deliberating, debating and discounting the possible outcome of trade negotiations.

 

Brexit, Indian and Australian elections do provide distinct and usefully alternative opportunities- all following instructive historical templates (UK’s pre-2016 referendum, Indian (UK) Hung parliament and Labour Victory templates), that we will seek to exploit. And yet the market will largely remain focussed on the Trade War and dominated by a simple metric: A resolution of US-Chinese talks is good for stocks the Dollar and ‘risk’ instruments and an escalation or lack of resolution is bad.

 

This binary approach, however, is misleading and does not reflect what is really going on in either the real economy or markets. And perhaps evidenced by what has been an erratic trading week and probably more so next week. Indeed, through the erratic price action in German DAX it is clear that it is setting up one of its most lucrative trading opportunities but in the short term only.

 

Here is our Friday update provided to subscribers:

 

The emotional swings this setup typifies neatly combines the persistent trade war narrative and our series on emotional trading. Understanding the underlying (economic and corporate) reality is important. But also appreciating how traders react and why is useful not only to forecasting price action but how one manages oneself through often violent moves that suggest sustainability but then reverse. Previously we highlighted the impact of emotions on trading decisions. Then explained how emotional balance can affect one’s ability to recognise emotions and neutralise them. Over the next two weeks we investigate emotional intelligence in the context of the current market. That is how we can to make emotions work for us, instead of against us.

 

The raging debate about a trade war inspired stock or dollar top versus a continued uptrend (that seeks an immediate resolution) has and is likely to continue for quite a time yet. Although no dates have yet been set for further talks, both sides spoke fairly positively last week, and it is likely that progress will continue, with some commentators pointing to the G-20 Summit in Osaka, Japan on 28-29 June that both Presidents will be attending. Meanwhile, we now see support for the measures appearing from Trump's Democrat opponents, meaning he will have no difficulty tightening the screws even further if necessary.

 

The ongoing effect of what appears to be a continuously uncertain process should be viewed in three (long, medium and short term) time frames. And the probability of each outcome in each time frame reduced by the extent to which individual players (politicians, negotiators and traders) can influence proceedings and markets. This week’s newsletter outlines these differentiated time frames, the role of individual emotions and how successful negotiation and trading is a function of emotional intelligence.  Next week we explain more fully how successful trading in the longer term really does depend on emotional trading intelligence but, unlike normal intelligence, can be continually learnt rather than acquired at birth.

 

Three Time Frames

 

Long Term Fundamentals
The first and longer-term implication is that protectionism is bad for the global economy and eventually affects markets. There is little politicians (and indeed any amount of bullish stock sentiment) now can do to remove the dent to the global economy and eventual market reaction. Emotions therefore play little part in the longer-term outlook. The IMF has downgraded global growth forecasts.

 

And yet emotion and sentiment driven stocks remain relatively strong particularly in the US and particularly versus the Chinese stock market.

 

The reason is that both the protectionist (US) economy stock market and the currency benefit, or rather are seen to benefit, from both an uneven inflation and substitution effect in the shorter term. However, the impact of consequent slowing economic growth will ensure an eventual reversal—evidenced by the reversal in the more fundamentally/less sentiment driven bond markets and the delayed, but surely turning down Dollar that is the combination of the two.

 

The question is therefore when will the stock markets follow and reflect this economic deterioration.

 

And in this we are still guided technically by the clearest stock market of all, the Russell.

 

Once we have seen the retest of the underperforming Russell (and by implication 1929 and 1987 style blowout SPX and NDX new highs) then not only can we expect a crash much larger than Q4 last year (wiping out Trump gains) but a significant reversal in the US-Chinese stock market relationship.

 

Until then (as previously explained) we expect sentiment about stock prices, corporate earnings and buy backs and ironically lower bond yields to drive the markets into what we believe will be the biggest 'buy the rumor buy the fact … oops sell' resolution to the Trade War.

 

Although this chart shows the price action is consistent with a possible top, the fact we have not seen such a resolution suggests, until then, the market will remain stable to strong.

 

Medium Term Sentiment
Last week we explained how this will, therefore, remain a sentiment driven market and how the seasonal 'Sell in May' market aphorism will help condition what we believe is a correction.

 

This seasonality fits neatly with the historical match with the Russell 2000 in 2014, which combines similar sentiment and price action.

Given the projection of an average potential US stock bottom around May 24 this suggests the next two weeks or so will see markets driven erratically and violently (hence emotionally) by the trade war negotiations, announcements and tweets, themselves subject to the posturing (and hence emotions) of US-Chinese negotiators.

 

Short Term Emotions and Strategies.
Economists and Game Theorists will tell you all players should recognise free trade and/or a trade resolution is the optimal aggregate solution and therefore all players have an incentive and will desire and eventually secure this outcome. In this respect anything else could be regarded as detail. And yet we have to wait, live and trade the noises and posturing in the interim until such time that the US administration has secured a sufficient significant and lasting shift in the trade balance and China is forced to agree to re-ignite economic growth. The market will therefore remain subject to tit-for-tat announcements that is likely to prompt two-way volatility until it becomes clear a deal can be struck.

 

Knowing what drives the tit-for-tat announcements and anticipating the next violent swing would be ideal. Knowing how each side is interpreting the other’s strategies, tactics and emotions in what is becoming an increasingly emotional conflict is the key to the day by day swings and the timing of the ultimate resolution and therefore blowout and crash.

 

Clearly Donald Trump has a vested interest in keeping his Make America Great Again barometer, the US stock market, as high as possible until his re-election. Using the nationalist trade war platform will help maintain the electoral colleges that secured him victory in 2016. But only provided it does not undermine the manufacturing base he sought to revive. The recent deterioration in economic improvement has started the clock ticking and raising the temperature of negotiations as reflected by last week’s announcement. And ironically the greater or faster the deterioration the bolder he is likely to become in forcing a resolution with China.

 

On the other the Chinese are known for playing the long game and possibly therefore willing to hold out until the US election on November 3, 2020 when Trump may be replaced by a less aggressive administration, an issue which President-for-life Xi does not suffer from.

 

However, the cost of the trade war in the interim is likely to be too great. Indeed, a very clear prognosis for the Chinese stock market (supported by the outlook also on the Chinese Yuan and curiously the analogous Oil market) suggests an agreement will be sought and found before November 2020 even if it is a holding agreement until after the election. And that therefore in the next few weeks there will be a significant buying opportunity in the Shanghai for the run in and resolution.

 

We cannot be sure what either Trump or Xi or the negotiating teams will say or do next. But we can be sure the markets will remain increasingly volatile until such time as an agreement is likely when stock markets are likely to blowout, the dollar remain benign and the bond markets indicate a reversal is imminent. Knowing how traders are reacting day by day to this volatility is useful. Knowing how we should and will react is key…

 

In the blowout, we should bear in mind the sagacity of Kipling …

 

... but then into the crash we might bear in mind the words of American humorist and playwright Jean Kerr.

Here’s to making the very best.

Good Luck

 

 

Ed Matts
Founder
Matrix Trade

 

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