Making Better Decisions Trading in the Markets

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Making better decisions trading involves knowing how markets function and what they value. Markets are information discounting mechanisms. Where markets go is not based on what things are at face value but what transpires relative to expectations that are already built into the price.

To better illustrate this concept, let’s first consider an example.

On July 31, 2019, the US Federal Reserve cut rates for the first time in over a decade. The market, however, wasn’t impressed with Fed Chairman Jerome Powell calling the decision a “mid-cycle adjustment” and “not the start of an easing cycle”. At one point, stocks were down 2 percent, gold fell, and the dollar strengthened.

If rates are lowered, it is assumed that those particular assets should behave opposite to how they actually did. Stocks generally increase in value from lower rates based on the way discounting works through the net present value effect.

Gold goes up because of lower yields in fiat currencies, which causes wealth to flow from lower-yielding currencies and bond markets into alternative safe havens.

The dollar goes down because it yields less to those who hold it, making it a worse investment.

The opposite happened because going into the day, 30 basis points of easing were expected based on the dollar-weighted average opinion. The Fed cuts rates in multiples of 25’s (that is, 0.25 percent or 25 basis points). But some market participants – about 20 percent of the fed funds futures rates market – were betting on a cut of 50 basis points. On a weighted average basis, this put the expectation at around 30 basis points. When the Fed cut 25bps, the front end of the curve actually tightened 5bps.

As we can see below, the general shape of the forward fed funds curve is inverted. Traders already expect the Fed to cut rates. If they cut rates, but not to the extent priced in, it will act as a tightening influence on markets, holding all else equal:

fed funds curve

The Bloomberg Terminal also shows the probabilities in numerical format:

fed funds bloomberg

In the very right column, it shows the weighted average odds of where the fed funds rate is likely to be by when. Before the July 31, 2019 Fed meeting, the rate was 2.40 percent. By the July 2020 meeting, it’s expected to be all the way down to 1.48 percent. If the Fed only cuts to 1.65 percent, they are easing less than what’s discounted in, which has the influence of effectively tightening policy.

The CME Group has a tool that shows where the fed funds rate is by certain points in time:

fed funds cme

This illustrates a primary reason why financial markets are a difficult game. To make money in the markets (outside of being long financial assets and relying on beta-related returns over time), you have to bet against the consensus and be right.

It’s not whether things turn out “good” or “bad” but rather how they turn out relative to the consensus.

For example, when a public company reports earnings and they share great progress in their business – growing revenue, expanding margins, positive earnings, increasing cash flow, new projects and initiatives – sometimes the stock will go down.

How can this happen?

While in certain cases it might be idiosyncratic market behavior (such as a large player selling), more often than not it’s because the new data that was integrated didn’t meet the expectations of the market.

And sometimes the opposite happens. A company has a negative earnings report or piece of data, but it is less negative than the market expects. This sends the stock up based on a positive re-rating in the discounted future.

Applies to central bankers as well

Central bankers, like traders, should absolutely heed attention to what’s discounted in the curve or have some sense of what the forward expectation is numerically. Their decisions have big ramifications for global markets and economies.

What financial market participants think is not just a “side opinion” but reflective of those involved in making the decisions that make the economy function. The financial system is what provides the capital (money and credit) that feeds into spending in the real economy.

The dollar-weighted average opinion of market participants is more likely to be accurate relative to a one-person / one-vote majority system dictated by a small central banking circle.

Central bankers are intelligent people, but they look at different things and weight certain data differently than “finance people”. Accordingly, they have different reaction functions. This has created opportunity in the rates market – in particular, shorting the front month fed funds futures contract going into the meeting given the market weighted average opinion is that the Fed would ease more than expected.

On the same token, while front month fed funds contracts have been strong shorts, long-term rates (looking out more than two years), favor being long. The US is very likely going back to the zero lower bound in the next downturn. The fed funds market prices in 75bps of easing over the next year. But then it extrapolates this rate going forward as a type of terminal rate, as illustrated in the first diagram in this article.

Thinking out over the next three years, with the odds of a recession certainly above zero (which would in turn be countered by short-term rates returning to zero) and the odds of rates staying above 2 percent are low, the market pricing in 1.4 to 1.5 percent for the overnight rate is likely too high. In the eurodollar market, fed funds is priced to bottom in Sept 2021 before ascending again, which doesn’t seem likely.

Whatever the opinion, the general idea is that winning in the markets is all about having a view that is different from what’s priced in. Believing that rates will go down does not mean that buying bonds or stocks is necessarily a good idea off the basic knowledge that lower rates raises the prices of financial assets more generally. Rather, it’s about how things will turn out relative to the embedded market consensus.

Conclusion

Stocks are at or near record highs because 3-4 cuts are discounted into the curve, and not because of what’s happening in the numerator (e.g., growth, earnings, cash flow). It may seem confusing to some how the Fed can cut rates with the stock market where it is. But markets are information discounting mechanisms. It is not a perfect measure of the economy.

If you are looking at trading a stock, you should look at what’s discounted into the future price. Across the internet, you can find forward estimates of a stock’s expected revenue and earnings per share (EPS) expectations over the next several quarters.

Even then, it’s not easy given company representatives will often release forward guidance at the same time as earnings, which will re-rate expectations of what will occur in future quarters. This is often what happens when a stock goes down despite beating revenue and earnings expectations. After all, markets are forward looking. Whatever it’s earning right now is more or less already embedded in the price. You have to think out several quarters or years and imagine how the world might be different relative to how it is today. Earnings reports are technically backward-looking indicators (similar to GDP and inflation readings for those trading macroeconomic trends).

Making better decisions trading involves a shift in mindset from how most people view markets. Understanding what’s already priced into the market, and having an out of consensus opinion that is correct, is essential to coming out ahead in the markets over the long run.