How to Trade the Markets You Have, Not the Ones You Want

Big Worm, played by Faizon Love, is the neighborhood drug dealer in the 1995 movie “Friday.” Big Worm weighs over 300 pounds and sports a head full of curlers. And as it turns out, Big Worm has a couple of insightful quotes in the movie that can help us as we try to make sense of the markets that are in front of us now.

In an exchange with Smokey, played by Chris Tucker, about late payment, Big Worm explains “I had to warn you too many times about my money…You see, it’s the principal. There’s principalities in the whole thing.”

When it comes to US economic growth, there are certainly “principalities” in the whole growth thing.

Because GDP is reported on a severe lag, its important to dial into aspects of the market which can tell you what’s currently happening with US growth. Historically, the strongest economic times in this country have been accompanied by a strong US dollar and elevated or rising interest rates. This was the environment in the US in late July 2012, when interest rates bottomed and started to rise. 

Watching the US Dollar

The US Dollar (USD) had already bottomed in late February 2012 and was on the rise. The USD has gone on to trade at 10-year highs and US Yields, although still in a multi-decade downtrend, are still trading well above the lows of 2012.

The corresponding US economic growth as been a quarter over quarter acceleration in the annual GDP growth rate from Q2 2013 through Q1 2015. So far in 2015, annual GDP growth has decelerated each quarter since peaking in Q1 at 2.9%.

This slowdown in growth has been accompanied by a downtrend in US yields, which peaked in the early Summer and a downtrend in the US Dollar, which peaked in mid-March. While there is no such thing as a Holy Grail or 'sure thing' in the world of trading, looking at USD, US yield and a couple of other select markets can give you a vantage point on GDP growth in real-time.

Your mission, should you choose to except it, is to find data points, markets or sentiment indicators to better help you understand what is currently happening. Most investors are either trying to forecast what is going to happen in the future or they're preoccupied with what happened in the past.

You can give yourself a trading edge if you focus your energy on getting better at understanding what is happening right now.

What's Happening Now

So far this quarter, US 10-year yields have gained 20 basis points, the US dollar is up 3.5% and the high growth US sectors are outperforming their slow growth counter parts by 955 basis points in the first 7 weeks of this quarter. That’s a massive out performance.

This tells me there's a strong likelihood that US GDP growth will accelerate higher in Q4 from Q3’s 2.0% growth rate.

As always, these markets bear monitoring for clues as to the future of economic growth because things can shift quickly. However, the “principalities” of the whole US economic growth thing have never changed. Strong yields, strong USD, strong US economy.

Another Big Worm quote worth discussing is “Playing with my money is like playing with my emotions.” 

Most people feel the same way about their money as Big Worm feels about his, that’s why most people aren't successful traders. The one thing that you can’t afford to do is get emotional about money.  Emotion clouds judgment.  Emotion leads people to become perma-bullish or perma-bearish on particular markets.

The moment that you become “perma” anything, you’ve already lost.  You begin to ignore data that's counter to your bias and only pay attention to the data that's supportive. This anchoring to a particular bias leads to you missing critical data that could clue you in to a potential change in the direction of a market.

The only two biases you want to strive for is perma-flexible and perma-agnostic.  Your sole focus should be on accurately determining the intermediate term direction of a particular market (up or down) and then pin pointing the appropriate entry point for that market.

Where I'm Long, Short and Neutral

Markets are dynamic and it’s important to consistently re-evaluate your bias based on the most recent data. Every weekend, I re-evaluate my bias for each market based on the latest economic data, policy changes and quantitative developments from the past week.

Here are my current biases: US Equities – NEUTRAL, Chinese Equities – NEUTRAL, US Investment Grade Corporate Bonds – NEUTRAL, US Treasuries – NEUTRAL, US Dollar – LONG, Euro – SHORT, Oil – SHORT, Gold – NEUTRAL.

I’m currently carrying a NEUTRAL bias on 5 of the 8 Focus Markets that I trade each week in The Whaley Report. It’s rare for me to carry a NEUTRAL bias on more than more than 3 markets in a given week.  In fact, its only occurred in 13% of the 155 weeks that we’ve been publishing TWR.

But given the current state of global markets and the state of central banking, I’m quite comfortable being non-directional on the majority of the Focus Markets.

As a quick reminder, a directional bias indicates that both the fundamental and technical picture are bullish (or bearish) and I believe a particular market will rise (or fall) in price. A NEUTRAL bias indicates that the fundamental and technical pictures are not aligned (one is bullish and the other is bearish, for example) and a particular market currently has an unclear direction and should be avoided.

The goal of the market bias, over time, is to capture the majority of the prevailing trend in a Focus Market and, more importantly, “catch the turns” and alert investors when the current trend ends and a new one begins.

How long will I maintain these biases?  I have no idea.  I'm trading markets in a time when unelected central banking officials rule the airwaves and demonstrate immense power over the flow of capital.

There is going to be a ton of action on the central banking front in the month ahead, which is even more reason to be cautious and non-directional.

There’s an old saying “Trade the market you have, not the one you want.” That 's the quintessence of my discussion up to this point.  It’s also important to point out that the quote implies that you should strip out emotion and any mental biases towards the markets that you trade.

Turns out Big Perm was wrong about being emotional with his money. Your action plan for this week is to evaluate every single open position you currently have to determine if your BIAS for those positions is still accurate given the development in markets over the last couple of months.

It’s also critical that you look at each market with a clear mind and without preconceived notions, especially markets where you have a currently open position. In fact, those are the positions that you want to judge most harshly.

One good way to mental prepare yourself for this type of evaluation is to ask yourself one question for every open position in your portfolio. If my portfolio was all in cash, would I be LONG (or SHORT) this position?