Thursday, May 13, 2010

Financial First Frost – in May?

First frost is a warning of things to come. Summer ends, winter approaches, and the seasons change once again. Time to put away your shorts and get out your woollies.

The action in the financial markets last week was should be viewed in the same way: a first-frost warning of change in the financial seasons.

Last week’s stock market mini-crash seemed to come out of nowhere. The story of Greek’s financial downgrading and rescue package was well know by May 6. Isn’t the stock market supposed to discount this type of news? Market technicians love to remind us that the stock market moves ahead of the news. Their theory is that the buyers and sellers somehow adjust their investment positions to take previously unknown risk into account. In this case, portfolio managers would have bought or sold currencies, stocks, gold, bonds, or t-bills to adjust for the new risk that Greece’s problems created.

But that’s not what happened here, is it? So far this month, every time new news about Greece appeared, the markets went down. And when the Europeans announced their bail out program, the markets recovered. The markets did not anticipate or discount anything: they reacted (over-reacted?) to every news announcement. And this week, the markets seem to have stabilized in reaction to the rescue package.

What does all this wild up-and-down action mean? Was last week’s volatility a first-frost warning of a change in the financial seasons, or was it just a freak spring snowstorm?

Last week’s significance is not in the news about Greece. Their financial fate will be determined by governments, big unions, and the gods of Mount Olympus. What’s important to ordinary investors is the volatility ― the explosion of wild swings in a variety of financial markets. In the months before the discovery of financial abuse in Greece, the markets had been quite boring. From day to day, they’d go up a little or down a little, but there was no real action. Then suddenly, just after 2:00 p.m. on Thursday, May 6, the Dow Jones Industrial Index dropped like a stone. At first, they blamed it on a trading glitch ― some trader added too many zeros to his sell order. Next thing you knew, the stock markets went wild, currencies went ballistic, commodities went crazy, and financial volatility spiked up. (Volatility is a measure of how far prices fluctuate in a short time.) It was last week’s volatility that is significant, not the news about Greece.

Times of low volatility, like the winter of 2009/2010, are sometimes referred to as the calm before the storm. The rule of thumb is: when volatility returns, the direction of the market will be in the direction of the volatility. Eruptions of volatility usually occur in two ways.
1. For the overall stock market, long-term tops often occur in times of low volatility and the increase in volatility triggers the markets’ new down trend.
2. For individual stocks, long-term bases often occur with low volatility. The stock goes nowhere, in a sideways trading range for a long time. When the stock moves out of that ‘base’ into an up-trend, it will be happen on increased volatility and volume of trade.

Thursday, May 6, 2010, (now called ‘fat-finger day’ because of the story that some trader accidentally sent in a sell order with too many zeros) witnessed a huge increase in volatility in many different financial markets. The direction of that volatility created first-frost warnings in the following new trends:
New Down Trends New Up Trends
1. Stocks 1. Bonds
2. Crude oil 2. U.S. dollar
3. Base metals (esp. copper) 3. Japanese yen
4. Canadian dollar 4. Gold

It’s time to test the old market technician’s notion that the stock market discounts the news. Fat-finger day gave us a clear warning that we are investing in high-risk times. Prices can change really fast. It’s time for ordinary investors to reassess the risk in their portfolios. It’s time to make those adjustments that will protect your investments from a possible repeat of the 2008 stock market decline. By doing the buying and selling now, you will be anticipating the next ugly financial news surprise and will not need to react to it. Bring in your harvest before first frost. Will you do it? Or will you react (or over-react?) to the next fast-breaking news story?


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