If You do the Work, You Short the Euro

Last week I came across an aspiring Forex guru that wrote in his journal that he expects “prices in EUR/USD to bounce to (much) higher prices from here.”

It’s important to seek out viewpoints that are contrary to your own, so I was intrigued to learn how he reached his opinion so that I could stress test my 2-year old SHORT bias in the Euro.

Needless to say I was sorely disappointed, for reasons I'll explore down the page. Let’s just say that this guy’s analysis would give Captain Obvious from the Hotels.com commercials a run for his money. But it got me thinking, how do you know if the recent 5% rally in the Euro is a change of trend or a shorting opportunity? 

The best investment processes are multi-dimensional. The best processes don’t just look at price action to make a decision but also evaluate and scrutinize the fundamental underpinnings of a given market.

A metaphor for this that I use is that trading is a lot like sailing. In sailing, the wind matters but the tide matters too. If you base every decision on what the wind is doing and you don’t pay attention to the tide, you crash into the rocks. 

In trading, price action matters but the fundamentals matter more. Market participants have limited insight into what’s really happening in terms of fundamentals. And any intelligence that could be behind their trading decisions is heavily outweighed by their emotional swings. 

Day-to-day, the market isn’t a fundamental analyst, it’s a barometer of investor sentiment. If you let the investing herd, which determines market movement, tell you what to do, and you make decisions solely based on price action, sooner or later, you will crash into the metaphorical rocks.

The analysis of fundamentals should always dictate your behavior for two reasons. 

First, no matter how a market trades in the short-term there is always a fundamental gravity pulling the market towards the appropriate price given the underlying fundamentals.

Second, because most investors have limited insight into the fundamental landscape and are further hampered by their emotions, understanding both the tide and the wind, can give you a marked advantage over other market participants. 

Now back to the Forex version of Captain Obvious. Each day this market player provides his subscribers access to his “trading journal,” which shows that day’s “high-probability trade analysis and set-up.” The very first trade that was offered was a LONG EUR-USD trade. 

I’ve had a SHORT bias on the Euro since July 28, 2014, so I’m constantly looking for bullish opinions on the Euro to see if my bearish bias still holds weight. Needless to say I was dying to see why this guy thought LONG was the direction. He wrote,

“EURUSD appears to be going incrementally higher in a stair-step fashion. Following a break-out above the resistance area (at about the 1.1060 price level), prices have re-traced back to this level. However, Friday's Key Reversal bar suggests that the old resistance level will become new support. I think prices in EURUSD bounce to (much) higher prices from here.” 

Let’s just say his “analysis” left me wanting. Actually, it left me wanting and bewildered. Is that what qualifies as analysis?

Of the four sentences in the analysis, the first two sentences are absolute facts that anyone with a chart and a pulse could have determined. The third qualifies as analysis, although I’m not sure a “key reversal bar” marks a significant development that leads to an edge over other investors. And the final sentence is obviously his opinion on the market in question. 

While I’m comforted to know he thinks the Euro is going higher, given that he is suggesting I get LONG the currency, I was troubled on two fronts. First, his level of conviction wasn’t what I would have hoped for. Second, if he thinks the Euro is going “(much)” higher then why is the profit target on the trade idea the high from just 7 days ago? I hardly think that looking at 8 weeks of price action to make a trade call is considered analysis. And I can promise you that a trading process based on a single dimension and a single time frame has zero edge in markets over the long run.

You’re better off indexing.

 

Time For Some Real Euro Analysis

Alright, I think I’ve made my point, now for a real analysis of the Euro and how you should trade it. 

The No. 1 thing to remember in trading is that no matter what your time frame, you don’t initiate long positions that are expected to lose money over the long-term because the fundamental gravitational pull is lower; no matter how compelling the short-term opportunity appears. 

The reverse is also true for SHORT positions in markets that are being fundamentally pulled higher.

As for the Euro, the gravitational pull is definitely lower, not “(much) higher.” When we are talking about currencies, the fundamental gravitational pull is primarily driven by 2 factors: economic performance and monetary policy. The Euro may have rallied 5.5% since early December, but the trajectory of both economic performance and monetary policy is exactly the same as it was when the Euro fell 25% in 10 months. 

I won’t bore you with a list of all the economic ailments that have been reported over the last 2 months but here are some highlights. 

The latest industrial production report showed that annual growth unexpectedly contracted for just the 3rd time since late 2013.
Germany, which is the economic locomotive for the Eurozone, has reported contraction in factory orders for 7 of the last 12 months.
The composite PMI, which is combo platter of activity for both the manufacturing and service sectors of the Eurozone, has been slowing for the last 2 months, while the Euro has been rallying.
The latest retail sales numbers were at the lowest level in a year and broke an uptrend line that started 3 years ago.
And finally, just a couple of weeks ago, the Eurozone cut growth and inflation forecasts for 2016.

This forecast reduction is a clear “all go” signal for the ECB.

Speaking of Eurozone monetary policy, Draghi has taken every speaking engagement for the last 2 months to reassure markets that he and the ECB stand ready to burn the Euro like a Salem Witch with a scarlet “A”. Just last week Draghi reiterated that it’s the ECB’s belief that quantitative easing is working and that any recovery that the Eurozone has seen is because of their efforts. 

He also said there is an increased concern over the global economy and the ECB will not hesitate to act if needed. I don’t know about you but I don’t know anyone who makes money consistently by trading against central banking policy.

To be clear, unless something shifts with the fundamental gravitational pull, Euro rallies should be used to initiate SHORT trades, not long ones.

That said, not every rally is a shorting opportunity. Tread carefully because the Euro could conceivably rally as high as $1.27 and still be in a significant bear market. Analyzing markets and trading profitably on a consistent basis is hard work and requires a multi-dimensional process. If anyone tries to give you trade ideas based on only one aspect of a market, run, don’t walk, in the opposite direction.