Picture Perfect

This past Friday’s market action was a picture perfect example of three things:

 It’s critical to know which economic indicators are valuable and which ones aren’t.

Markets aren’t perfectly efficient. 
If you have a process that you consistently follow, you can position yourself to capitalize on dislocations in the market instead of fearing them.

 I’m not going to digress into a rant about how ridiculous it is that every jobs report we have gotten since May 2013 has been “The Most Important Jobs Report in the History of Man.” 

 This past Friday’s report was no different in the eyes of media pundits.  The report showed that 74K jobs were added in December, missing consensus expectations of 205K jobs. 

 Despite the huge miss, the unemployment rate did decline from 7% down to 6.7%, within spitting distance of the Fed’s threshold of 6.5%.  Unfortunately, the decline was due in large part to a 347K decline in the labor force participation rate and not as a result of an overwhelming number of jobs being created.

 

Which Economic Indicators Are Valuable

 Investors get hot and bothered for the latest non-farm payroll numbers.  But the reality is that these numbers historically haven’t been valuable guides to understanding the direction and stability of the underlying economy. 

 The most reliable indicator for evaluating the labor market and its connection to the underlying economy has been the weekly unemployment claims that are published every Thursday.  Last week’s claims report hit a fresh 5-week low and year over year declines continue to accelerate.

 Knowing in advance that the non-farm payroll, historically, is not as valuable as the weekly unemployment claims will help you stick to your process.  It will also help you avoid being swept up if the market overreacts to a particular report, which it did on Friday.

 

Markets Aren't Perfectly Efficient  

 Anyone who has traded in real-time with real money for longer than 2 hours knows this to be true.  It’s not efficient because market participants have varying investment time horizons, information is not received uniformly and finally, not all information is interpreted in the same way by all market participants. 

 And yes, I’m aware that few people are able to outperform the “market” over long periods of time.  But the reality is that there are a fair number who do outperform for long stretches of time, decades even.

 Last Tuesday the market reacted to the monthly ADP payroll numbers, which were the highest since November 2012.  The broad market’s interpretation of this data was that it increased the likelihood of further tapering at next month’s Fed meeting.  Financial markets responded the way we would expect them to when pricing in further tapering: US Dollar + 0.18% (on the highest volume of the week), interest rates + 0.3%, Gold -0.6%, US Treasuries -0.27%.

 The market’s reaction to Friday’s NFP numbers was the exact opposite.  Investors felt like that number indicated continued frailty in the US economy and began pricing in no more tapering at next month’s Fed meeting.  Financial markets responded the way we would expect them to when pricing in NO further tapering: US Dollar -0.41%, interest rates -3.25%, Gold +1.5%, US Treasuries +1.2%.

 Does this sound like the way an efficient market would behave? 

 

Prepare For Success In Jumpy Markets, Don't Fear Them

 When markets react like they did on Friday it pays to have a solid process to fall back on and a framework to view the activity for making decisions.

 The first question I asked myself was: fundamentally speaking, has anything changed?  I looked collectively at the week to determine if the data this week would dramatically alter the Fed’s tapering.

 US trade balance improved, the deficit declined 13% to the lowest level since October 2009.  As I mentioned earlier, the month ADP payroll number hit the highest point since November 2012.  Mortgage applications increased 3% week over week, indicating that housing is showing a rare sign of life. 

 The most valuable indicator of the labor market, weekly unemployment claims, continued their descent and hit a five-week low.  And then finally, the NFP number on Friday. 

 On a net basis, this past week was solid for US economic reports and gave no indication that the Fed should abort its tapering at the next meeting.  The tapering playbook that we discussed a couple of weeks ago is still valid. 

 We entered the week with trade ideas for 6 out of the 8 Focus Markets, and we were able to execute 3 of those trade ideas last week.

 Wednesday's market reaction for more tapering moved the US Dollar (UUP) up 0.18% and allowed us to initiate our SHORT trade idea at 21.80.  So we were already positioned to take advantage of UUP’s weakness in the final 2 days of the week.  That trade idea is already profitable by 0.6% or twice our initial risk.

 We were equally prepared to take advantage of the 3.5% decline in rates that occurred on Friday.  LQD and TLT rallied 0.5% and 1.2% respectively in response to the anti-taper market response.  Both of those rallies allowed us to initiate SHORT trade ideas in LQD and TLT. 

 I will point out that both rallies occurred on above average volume, which would indicate a level of conviction by traders.  It’s also important to point out that this occurred on a Friday making it more significant. 

 That said, the risk with each of these trade ideas is minimal and we are certainly trading in the direction of the prevailing intermediate term trend.

 Why is the fact that it occurred on a Friday important?  Closing prices matter more than any intraday price movements because the closing price is the price at which traders take home their positions overnight.  If closing prices are the most important prices then the closing prices on any given Friday are the most important of all.  Because that’s the price that a trader must take his position home with him over the weekend.  A lot can occur on a weekend before a trader has an opportunity to adjust his positions at 9:30 on a Monday.

 I always get a little giddy when markets overreact and my process positions me to capitalize on the dislocation in prices.  While I can’t guarantee that the trade ideas that were initiated last week will be profitable. I can tell you from experience that trade ideas that are initiated counter to a market’s knee-jerk reaction and are in line with the underlying fundamental and intermediate term technical picture have a high probability of being profitable.