Crude Oil and the mood of the market
The famous value investor, Benjamin Graham, would often refer to the mood swings of the market. Depending on how the market was feeling, prices could either go up or down, without regard for fundamentals. This allows investors to purchase stocks when they are below their intrinsic values, or short them when they are too expensive. This is the basis of value investing and the correct approach when investing for the long term.
Over a shorter time span, things are different. If we want to actually make money in the short term from the seemingly irrational up and down movements, we need a different approach. Let's take a look at the oil market over the last few years. Prices are in $/barrel.
The rise from June 2000 to 2007 seems quite reasonable. The economy was growing over that period, and oil demand and prices rose in line with economic growth. The move from June 2007 to June 2008 is much less reasonable. Why would oil prices double, when the global financial crisis hit, and economies were going into recession? The high price didnít last very long, as once the recession hit, prices tumbled over the following six months. The downward move, though extreme, is more in line with fundamentals as a recession brings falling demand with it.
In June 2007, if an investor were to forecast that a recession in the developed world would occur (they would have been correct) they might have decided to short oil. Over 1.5 years, they would have made a good profit. However, in the interim they would have suffered heavy losses. Perhaps the losses might have been too high to keep the position open. This situation reminds me of quote from the economist John Maynard Keynes, "The market can stay irrational longer than you can stay solvent."
During the year in which oil prices steadily climbed to above $140, an interesting phenomenon was taking place. Upon the release of news headlines that were bearish for oil, the market would fall a modest amount in the day, maybe 50 cents or a dollar. When news headlines that were bullish for oil came out, the market would jump 1, 2, or even 3 dollars in a single day! The end result was that the market was rising, and this is because the mood of the market was bullish. The mood of the market for a commodity (or any asset) can be determined by examining the reaction to news.
In the example of the oil market, during the run up to $140/barrel, the marketís bullish mood stood in contrast to the fundamentals which were bearish (due to upcoming recession). This kind of market is great for long term investors as they can take advantage of the fact the fundamentals will prevail in the long run. They can expect to make a profit by going short and trading in line with fundamental analysis.
How can we use reaction to news analysis and underlying fundamentals to create an effective trading strategy? Trading is all about probabilities and we want to make trades that have the highest probability of success. News is a reflection of what is going on with the fundamentals. News can be about a companyís earnings, a countryís GDP growth, an oil spill in the Gulf of Mexico, or anything else. While we certainly canít predict the news, we can perform fundamental analysis on an asset to get an idea on what kind of news to expect. If we are bullish on a commodity, we are expecting more good news relative to bad news, and we expect the price to increase.
The next part of the analysis is the reaction to news. If markets go up more on good news than they fall on bad news, we can conclude that the market should rise. In situations where the fundamental analysis as well as the reaction to news analysis are in line (both are predicting the same thing) - we have a high probability of a successful trade.
A final note of caution: Short term forecasts can change quite rapidly. A market may have a bullish tone to it due to its strong reaction to positive news. However, one piece of extremely bad news is more than enough to turn things around, and push the market into a bearish trend. Thus, it is important to continually follow and analyze the markets and keep track of exactly how the market is feeling!
This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!
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