- Profiting from lack of change.
- Opportunities occur at those times when emotions peak and markets slip back in-line with their underlying determinants.
- A correlation to count on: commodities and the U.S. Dollar.
"Time is the friend of the wonderful business, the enemy of the mediocre", Warren Buffet
Gross Domestic Product & Retail Sales
The U.S. economy as measured by its Gross Domestic Product - GDP / see Figure 1-over the last 50 years has been a steamroller.
Figure 1. U.S. GDP
Fueled by retail purchases - Figure 2 -- the U.S. economy historically doesn't slow down, but rather decelerates, with those pauses coming every decade or so. Over the last 40 years we have spent approximately 3.75 years, or 9% of time in what economists call recessionary growth. With the economy in growth mode over 90% of the time, only one of those four recessions shows up in Figure 1 - that blip down in 2008.
Figure 2. Monthly Retail Sales
With such a strong long-term pattern of consumption in place, the U.S. stock market, as measured by the Dow Jones Industrial Average - see Figure 3 -- has predictably enjoyed historic growth as well, though it has followed a more violent path than the steady pull of those two underlying fundamental determinants, GDP and retail sales. The difference between the steady economic growth of the actual economy and the more zigzag, emotional behavior of the market marks the difference between non-change (measured economic growth on a long-term scale) and the perception of change (market pricing on a short-term scale). Warren Buffett summed it up best when he said: "Our approach is very much profiting from lack of change rather than from change".
Consumer Sentiment & Market Psychology
While investors would be better off focusing on the numbers the long-term trend of the U.S. economy produces rather than the manic behavior of markets, that would be counter to the nature of the majority of our population. People are not interested in boring long-term spending habits, they want excitement. A reminder of our emotional tendencies can be seen from these two social indicators. Number 1: the most popular genres in current book sales; and number 2: the consumer confidence index.
Most popular book genre of 2013:
52% Science Fiction
15% adventure / thriller / crime
We chose book sales over movies assuming readers are more thoughtful than viewers.
The Consumer Confidence Index:
While the majority of book buyers are more interested in an imaginative future and romance than on the economy, and our collective confidence in the economy swings more wildly than our stock market, that's ok. We are all emotional beings and that is not going to change in our lifetime. However, regardless of what we all read, or think, or post on Facebook, collectively we are currently solidly confident in the future now with the confidence index crossing into the upper half of its historic range. This chart in Figure 4 is an excellent indication that GDP and retail sales will continue their monotonous ascent. While Warren Buffet's advice that, "investors should remember that excitement and expenses are their enemies." seems anything but contrarian to experienced traders and investors, it is a great reminder to all of us to keep our financial planning separate from the rest of our exciting, imaginative, romantic life's.
Taking this a step further, the conflict between how our economy evolves - slow and sure - and how markets behave - exciting and emotional -- provides great opportunities at those times when emotions start to subside and markets swing back in-line with their underlying economic determinants.
Crude Oil, Commodities, & the U.S. Dollar
Three more charts of particular interest for us all are the crude oil market, the U.S. Dollar, and gold.
The price of crude oil - Figure 5 -- is important to us because it sets the rate which we pay to fill our cars with gas and it mirrors how much many of us pay to heat our homes. Lower oil prices put extra cash in all our pockets, and lower the cost of transportation and production for most businesses. The trend reversal we see in Figure 5 in crude oil over the last 2-months is a timely bonus for consumers and businesses around the globe, and it also serves to strengthen the U.S. Dollar - Figure 6.
As the price of commodities fall, the value of the U.S. Dollar rises. Unlike other market correlations which ebb and flow based on investors collective emotions, the long-term relationship between falling commodities and a stronger dollar is rock solid. Commodities are priced in U.S. Dollars, as they fall in price the U.S. Dollar buys more, i.e. it strengthens. One of the things even an economist can count on is when commodities go down the dollar will go up, and vice versa.
A rising U.S. Dollar also makes U.S. assets look more attractive to our trading partners around the globe. If the U.S. Dollar is rising against the Euro, or Yen, or Aussie Dollar then investors in those countries will want to move money out of their own currencies and into U.S. denominated assets such as U.S. securities or property. Likewise American's with assets overseas need to be concerned with the falling value of the currencies of their holdings.
With the U.S. currently shifting from an importer of crude oil to a net exporter, and technological advances making it possible to bring more and more oil to the surface around the globe - increasing supply - we have to read the current reversal lower in this market as an accurate reflection of the underlying fundamentals. For sure the price of oil is an excellent real-time economic indicator. That the U.S. economy is no longer dependent on Mid-East oil because we pump it ourselves from the Northern Great Plains and Texas is a game changer for the previous long-term uptrend.
While the price of gold has little effect on the economy directly, it has a good track record as a "fear" indicator. Falling gold prices are a psychological plus for the economy, while rising gold prices are seen by many analysts as a warning sign for future growth.
While it may be easy to dismiss the phrases "fear indicator" and "psychological effect" initially, psychology, or specifically investor's emotions, plays a critical role in market pricing - as we saw when comparing the swings in stock prices and consumer confidence and the steady performance of the underlying fundamental determinants. Based on the steady growth of the two inputs of GDP and retail sales the manic swings in consumer confidence and stock prices don't seem to make sense; until you view them from the lens of human behavior, i.e. psychology; or, in the language of the trading floor, "fear, need, and greed". Our emotions have an outsized effect on our perception of current and future value, which is why for all our historic growth, we still fear failure. In trading and investment parlance "buying the dip" means going against our fears and emotions; but it also means positioning ourselves in-line with the long-term trend in growth. In any investing or trading plan we need to differentiate the sharp emotional deviations created by perceived change from the long-term trend, i.e. non-change.
Looking at the current positioning of the markets themselves in these seven graphics, and understanding that the pattern these charts have created is a reflection of both the underlying fundamentals and investor psychology it would be hard to disagree that a bullish U.S. Dollar thesis going forward is the way to go.
Jay Norris is a Trading Instructor at Trading University and wrote the 2013 best seller The Secret to Trading: Risk Tolerance Threshold Theory.
Disclosure: The author is long UUP.