It's Fundamentals That Drive our Oil Trades

Last week’s market reaction to the new round of easing from China and the promise of further action from Draghi and the ECB is a good reminder that central bankers and the media have a lot in common with magicians.

They're both good at getting the audience (investors) so focused on what’s happening in the right hand that they fail to realize that what really matters is happening in the left hand.

I won’t make you wait for it - in the left hand is the fundamentals.

Yes, I know, it's not sexy to talk about fundamentals, especially when markets are ripping to the upside. Anyone with an internet connection can pull up a chart and see that all of the world’s Its’equity markets have been on a tear since late August.

But just because markets are up 10-30% off the August bottom doesn’t mean the environment surrounding those markets has changed. In fact, the fundamentals have deteriorated in the last 2 months, not improved.

Anyone who follows the NBA knows that the Spurs forward, Tim Duncan, is nicknamed “The Big Fundamental.” As you might imagine, he got his nickname because he is one of the most fundamentally sound players to ever lace up.

That said, his play is boring to watch. I’m not sure he has ever made a Sports Center Top 10. But boring or not, he’s going to go down as the best power forward of all-time; he’s won 5 NBA titles, 3 Finals MVPS and 2 regular season MVPs among a long list of other accomplishments.

It should also be noted that his last title came just a couple of years ago, at the age of 37, against the much sexier, Big 3 down in Miami. Not even, the best player in the world, Lebron James, could stop the Big Fundamental. The Spurs outscored the Heat by the largest point differential in NBA history.

Fundamentals may be boring but trust me when I say that price movements only have meaning in the context of the fundamental landscape. The word “fundamentals” means different things depending on what trading instrument you are discussing.

If you are talking about an individual stock, then you’re referring to the underlying fundamentals of the company. If you’re discussing a commodity, like crude oil, then you are referring to the supply and demand of that market and the impact of OPEC.

Finally, if you're discussing the fundamentals as they relate to a country’s equity indices, currency or government bond markets, then the fundamentals are about growth, inflation and central bank policies.

A misconception about fundamentals is that to understand them is to forecast them. I don’t put a lot, if any, stock in forecasting.

The most advanced weather systems in the world aren’t accurate outside of the next 96 hours, how could we possibly expect to forecast out a month or 3, in a system as a complex as the global economy?

No, to understand fundamentals is to better understand whether it's raining or sunny today, not what the weather is going to be tomorrow.

Back in the Financial Crisis, housing prices peaked in June 2006, subprime indices peaked in January 2007, money markets dried up in August 2007, the S&P 500 peaked in December 2007. These events went largely unnoticed by market participants. Lehman Brothers collapsed a full 9 months later in September 2008 but the warning signs started 18 months before that event!


Fundamentals In The Oil Patch

Most of our 32% return this year with TWR trade ideas has come from our 4 trade ideas involving OIL.

The crude oil market and our resulting trade ideas are a clear example of why understanding the fundamentals of the market you are trading can give you a decided advantage over other market participants.

We’ve closed 3 OIL trade ideas for 7%, 7% and 8% gains respectively. Our one open trade idea is up over 10% as of Friday’s close.

Our first trade idea in OIL this year occurred in late April, a full 10 months after this market peaked. Understanding the fundamentals of this market allowed us to initiate a SHORT trade idea in the midst of a 30% rally from the end of March through the first week of May.

We initiated our first trade idea on April 30, which turned out to be just 6 days before OIL hit an intermediate term top. How could you know that a 30% gain wasn’t a change of trend without the fundamentals? How could you know that you should use a 30% gain to get SHORT rather than going with the herd and getting LONG without the fundamentals?

We’ve had 3 more profitable SHORT trade ideas since then, all while most market participants have been trying to catch a falling knife. The fundamentals of this market once again told us to get SHORT OIL on October 8. On that date, OIL had rallied 35% off the August lows.

Once again, SHORT-ing OIL was a contrarian move if you watched the actions of others. But if you understood the fundamentals of the OIL market, you saw a 35% move up as a huge opportunity to re-initiate a new SHORT trade where the reward to risk was skewed heavily in your favor.

Better understanding the underlying fundamentals of the instrument you want to trade gives you an edge because most market participants have limited insight into what's really happening. I think this is because most market participants are first-level thinkers.

Understanding the fundamentals and understanding macro takes more work than looking on a chart and seeing a 200 day moving average or an equally useless Fibonacci level.

Frankly, even if most market participants were dialed into the fundamentals, any intelligence that could be behind their decisions would be overridden by their emotional swings. The day to day swings in the market are nothing more than a barometer of investor sentiment.

If you hope to earn out sized returns, then your analysis of the fundamentals should dictate your behavior, not what everyone else is doing. If you let the market mob, which determines price movement, tell you what to do, how can you expect to outperform them?