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Inefficient Pricing Models Defy Gravity

Written by A Forex View From Afar on Monday, July 27, 2009

The recent equity market rally had a strong driver behind it; investors’ optimism, which has helped the financial market sustain one of the longest trends of the last few years.

In trade on Monday, equity markets are heading higher for the eleventh consecutive day, the longest streak of the last few years, and a similar pattern to the period when the housing and credit bubbles were being inflated. In particular, the Nikkei closed in the green for the 9th consecutive day, making the current rally the longest in a little more than 20 years.

However, the present rally seems to defy the macroeconomic picture, some are saying. The global economy is still in a contraction phase, even though the pace of decline had a noticeable slowdown, the unemployment rate is projected to surge to around 11%, although just a few months back the estimates were pointing out to a 9% rate. Add to that the fact that the consumer spending sector appears to be deep in contraction, as credit card defaults head towards record highs in U.S. and European markets. Moreover, the major central banks together with the IMF forecast a slow recovery period, which would have a strong weight on both consumer and business revenue streams and expenditure.

Despite these issues, investors have been lured by the number of companies that had better than expected reports in the Q2 earnings releases. Out of the nearly 200 major companies that reported so far, a huge majority beat analysts’ estimation, probably making Q2 appear as one of the best earnings quarters in history. Things are not so rosy after all, it would seem, since the reported earnings so far are lower by 30% than the numbers seen in the second quarter of 2008.

This confirms, via a reduction in income, that consumers have indeed cut their spending, and that is not something that is expected to pick up anytime soon. There is a huge slack in the global economy right now, something that will further delay the recovery period. The current situation has the feel of the April 2009 rally that was initiated by the Federal Reserve, but then fueled by earnings reports.

To some extent, this shows again that the stock market does not reflect the state of the economy, but rather the outlook of the public companies as weighed by investors. As long as the remaining companies continue to beat expectations, chances are that the current rally will continue. Suddenly, 1000 points on the S&P does not look so far away.

Moreover, the current rally shows once again that the free markets are rather inefficient, even though the pricing models that most investors rely upon are built on the market efficiency hypothesis. If the equity rally continues the traded market will see inflated equity values, higher commodity prices, and a lower Usd, all backed by an inefficient valuation model. The issue with that is the ease in which those values can realign themselves, especially when not backed by robust employment, access to credit, and diminishing income flows.

The divergence is also being seen in oil prices, a market where speculative interest has increased in-line with equity valuations going higher. The perfect example of automated trade that has been allowed to grow, with nothing programmed to cover the lack of foundation in the corresponding market. Global oil consumption is forecast to move lower in 2009, but to keep aligned with inflated equity valuations, the pricing models are sending out buy orders, like equities, that do not match the forward valuations. Something will soon give, in the form of price reduction, or economic expansion that gets things aligned. Right now, the economic expansion thought process looks as flawed as the inefficient pricing models that run the automated order process.

The final line in the equity play may be the question of where the XLF is trading. The financial sector historically has lead or backed each sustainable move the equity markets make, and throughout the recent rally, the XLF has been stuck trading around the $12, and held there for the last two months. The markets are not rallying financials, and as such a red flag is running up the pole

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Fundies and Trading
There is a constant question from some traders as to why anybody would ever need to consider the ‘F’ word when trading. Fundamentals: what is so damaging at looking at both Technical charts and having a Fundamental filter to gauge how many Lots to put on? Why is it that accepting that Technicals give us price points to trade, but Fundamentals determine the direction that we travel is so difficult for some traders to accept? Without a Fundamental Filter very few pure Technical traders would have seen this Dollar move coming today.

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