The key equation for turning points in currencies,
as in all financial markets, is:
extreme consensus + extreme speculation = extreme price.
During the 1980s, currency observers discovered that the currency markets resembled other markets much more closely than they had imagined. They were ruled by hope and fear. They trended more or less like other markets, and got overbought* or oversold*, just like other markets. The similarities are so great, in fact, that it’s easy to err on the side of forgetting the dissimilarities. Here are some dissimilarities.
1) The main market for the currencies is made by the world’s banks –the so-called inter-bank market* . It has no statistics. The principal vehicle for quotations is the video screen. It operates 24 hours a day.
2) The currencies are a pure zero-sum-game* , the only one in fact. It means nothing to say a currency has risen except that another has fallen.
3) The forex* markets are the only financial markets in which there is official intervention* – by central banks. No wonder: for every country but America, a rise or fall in the currency raises or lowers dollar GNP in proportion.
These differences have various implications. 1) For statistics we have to go to Chicago’s IMM, the main futures market. Although it only turns over some $10bn per day, as against a purported $6OObn+ in the interbank markets, the IMM accounts for a significant fraction of all non-bank activity, especially speculative activity. This is important, since most bank activity is merely a clearing function, i.e. just froth.
In a pure zero-sum game 2), there is no such thing as a crash. Taken as a whole, the players are never wiped out –in fact their wealth stays the same all the time. You win or lose only by playing better or worse.
Finally 3), intervention. Though those central banks are high rollers, they are swamped by the massed ranks of traders. Also there is a strange phenomenon with intervention. After the initial shock of the first round of an intervention phase, traders –especially big operators on bank dealing desks and multi-national treasury departments –seem to love “taking on”
the central banks. This means the struggle is more even than you might think, at least in the early stages of a prolonged intervention. On the basis of experience to date, I believe the following rules will payoff .
1) Most intervention is against the trend. It is best to ignore it completely at the outset (and stay with the trend).
2) In due course sustained intervention will absorb all the opposition, including a lot of speculative opposition. This will show up in various sentiment gauges (see below).
3) At this point the trend will be on the turn. And the imperative rule for intervention in the same direction as the trend is to go with it at all times.
That lot boils down to a very simple formula. Ignore all intervention unless/ until it’s in the direction of the trend, in which case go with it.
The key to trading financial markets successfully is to be on the right side of the “big moves”, which are often measured in years. That’s easily said, but to do that we have to be able to locate the start of the big move and also its end. In the currency markets, as with all financial markets, the extremes of the big moves are invariably attended by certain psychological characteristics, reflecting degrees of hope and fear among the players.
But the big moves –or underlying trends –are composed of smaller multi-week or multi-month moves. And the extremes of these moves too are marked by the same psychological characteristics or behaviour patterns. So there may be no way of knowing whether a turning point marks a change in the major underlying trend or just a correction which leaves the main trend intact. Moreover, these minor moves are usually made up of smaller multi-week or multi-day moves with similar attributes. And you can go on. Within a single day, you find the same pattern of alternating fluctuation between bullishness* and bearishness* measures in hours and minutes and even seconds.
The mathematician Benoit Mandelbrot coined the word ‘fractal”* for this phenomenon of patterns that contain similar patterns within them, some– times ad infinitum. It has also been called “ scaling” , because of the way such patterns recur on different scales, up and down the dimension spectrum. The fractal phenomenon seems to lie at the very heart of nature –within the genetic process itself –though one of the first places Mandelbrot saw it was in series of soybean prices.
In all markets, price extremes are usually attended by a consensus that the trend, be it up or down, will continue; and by a peak of speculation in line with the trend. Hence the excruciating paradox of financial markets,
that sentiment is most bullish at the peaks when prices have only one way to go which is down; and most bearish at troughs vice versa: at the top there’s no– one left to buy, and at the bottom n0-0ne left to sell. This paradox is absolutely central to the working of all financial markets and we need all the help we can get to understand it so thoroughly that it becomes part of our nature. The more bullish things are, the more bearish they are. Bullishness is born as hope in the midst of despair. Hope swells to confidence and confidence swells to euphoria, and the process contains the seed of its own destruction and the birth of its opposite, fear. Fear is nurtured by falling prices and the two feed on themselves until they swell to despair. And so the cycle is completed –and ready to begin again with the birth of hope. This is both the way things are and the way they have to be. We haven’t understood the process until we have grasped that. The despair creates the price trough: the price trough creates the despair. The price extreme is the definition of the extreme of despair, which is in turn, by definition the moment when hope comes to prevail; hope feeds and is fed by rising prices until the peak of price and euphoria leave prices with only one way to go, which is down. This circular process underlies every price fluctuation in free markets from the smallest one measured in seconds or minutes to the largest measured in years or decades. So it has always been and so it will always be, because it must be. The ancient Chinese symbol called T’ai-chi T’u or “symbol of the ultimate reality”, more commonly know as the yin yang symbol, is delightfully appropriate to the way markets are – and uncannily appropriate to the way currency markets are. It is up to each of us to see anything in it we find helpful. This exquisite symbol of the Tao* works at many different levels, in many dimensions. You choose your own levels and dimensions. We can see the light and the shade as representing opposites like bullishness and bearishness, hope and fear, sympathy and antipathy, consensus and dissension, speculation and prudence, euphoria and despair, illumination and benightedness, yin * and yang*. We can see the thin and thick ends of each tadpole as representing the beginning and end of something; the wax and wane; the birth and death. The light is born out of the pitch of the dark, and the dark out of the fullness of the light: the small circles within each half represent the seed of the other half. The whole is a circle, with no time scale. It can be accomplished in seconds or
in years. It goes on and on, round and round, scaling. This is precisely the way of markets and market sentiment. It is the Tao* of markets. Any time you should find yourself assailed by extreme confidence or despair,
