What really drives the market to move up or down? Is it logic deriving from numbers, fundamentals, or news? If it’s logical, then everyone should derive the same conclusion, and the market should move accordingly.
However, this is not always the case, as demonstrated in the U.S. stock market in 2006-2007. Despite negative news and deteriorating fundamentals, the market continued to rise due to the emotion of greed.
Greed, defined as a very strong wish to continuously get more of something, causes markets to go up and become bullish. As more and more traders and investors buy in, the greed intensifies, resulting in explosive returns for those who entered early.
On the other hand, fear is the emotion that causes markets to go down, as traders and investors sell to avoid unpleasant emotions and financial loss. In the crisis of 2007-2008, fear eventually became the dominant emotion and led to panic selling, causing the markets to crash.
Successful trading involves being able to determine which emotion is more dominant in the markets. By measuring the overall collective emotions of greed and fear, traders can identify signs of a bullish or bearish market and make profitable trades. As long as traders can accurately determine which emotion is dominant, they can be successful and
earn substantial profits.
Why I Don’t Use Fundamental Analysis Or News For Trading
There are two main types of analysis for trading, and one of them is fundamental analysis. This type of analysis is based on news reporting on numbers, such as revenue, earnings, and profit numbers for companies (if you are trading stocks), or economic indicators like job numbers and employment numbers (if you are trading forex).
To be successful with fundamental analysis, you must be familiar with metrics like the price-to-earnings ratio, earnings per share, non-farm payroll, and the Federal Open Market Committee’s (FOMC) decisions on interest rates. You need to not only be familiar with these numbers, but also be able to interpret them to come to a conclusion on how to trade them.
In essence, fundamental analysis involves looking at numbers, following news, and interpreting what it means for the markets. As I’ll be mentioning later in this book, the fundamentals showed that the situation was going from bad to worse before the crisis of 2007-2008. However, prices continued to move up another 20% to 25% over almost a 2-year period before the crisis finally hit.
This is one reason why I don’t use Fundamental Analysis in my trading. It’s not that fundamentals do not work, but they do not work the way traders want them to.
Let’s take the previous financial crisis as an example. In January 2006, the Dow Jones Index was around 11,000 points. By July 2007, roughly one and a half years later, the Dow Jones Index had already gone above 14,000 points, an increase of roughly 25%. One would think that during this period, fundamentals and news should be good, but that’s not the case.
Several bad fundamentals and news were announced during this period, such as the US home construction index being down 40% compared to the previous year, HSBC announcing losses of $10.5 billion in their US mortgage lending business, and several subprime lenders declaring bankruptcy.
However, despite all the bad news, markets were still going up, with Citigroup and all other major banks being near their all-time highs in May 2007. In fact, Citigroup was just 7% shy of its all-time high.
The market continued to climb, not because of fundamentals or news, but because of greed. In July 2007, Dow Jones’s futures went above 14,000 points for the first time in history. However, towards the end of 2007 and the start of 2008, the market began to come down, and in one and a half years, from October 2007 to March 2009, the Dow Jones dropped from its peak of 14,000 points to below 7,000 points, wiping out more than half of its value.
The market started to go down not because of fundamentals, but because of fear. As you can see from the example, fundamentals take time to work. It may take a
day, a week, a month, or even years for fundamentals to take effect. And as traders, we need to be able to time the markets accurately. This is why I prefer to use technical analysis to identify signs of fear and greed in the market.
The Power Of Technical Analysis
Technical analysis involves studying price movements to determine current trading conditions and future price movements. By looking at both historical and current price movements, traders can make more informed decisions about when to buy or sell.
The basis for using technical analysis is that all past and current market information, mainly related to greed and fear, is reflected in price. If price reflects all information, then analyzing the way price moves, whether greed or fear is dominant, is all a trader would need to make a trade.
Technical analysis typically involves charts, which are the easiest way to visualize historical and current data in a graphic form.
Now, you might be thinking, “Technical analysis! Charts! It must be complicated and hard to understand.” Here’s one thing I found out about technical analysis: if it’s complicated and hard, it will not work. And I am speaking from experience. I tried complicated charting by using numerous indicators and drawings on my charting, and it did not work for me. Charting only started to work for me after I began to keep it simple.
With the right combination of indicators and the right parameters, I was able to consistently get high probability winning trades that gave me an explosive return.