What traders can learn from the markets' reaction to the S&P warning

Trying to forecast markets based on current events (or fundamentals) is a hopeless task, says John C Burford. The key to forecasting is to keep a close eye on what everyone else - the herd - is doing. And all is revealed in the charts.

In a recent post, I expanded on the idea that trying to forecast the market based on the news (or fundamentals) is a hopeless task. I gave the example of the dollar, where I painted equally plausible scenarios which gave diametrically opposite forecasts.

While this is fine for economists, for traders it's a little unsatisfactory. So is there a better way to forecast markets?

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Just as I was writing that piece, along came an item of news that shook the market up the warning from credit rating agency Standard & Poor's that it might downgrade the sovereign debt of the US from its pristine AAA top rating.

If you knew nothing about technical analysis, what would be your guess as to the impact that news 'should' have had on the markets?

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I'm confident most people would say that it would be bearish for the dollar, for US Treasuries, and possibly for stocks.

The link to Treasuries is pretty obvious, as investors would demand higher yields for the perceived higher risk.

Note that I said perceived, which is an entirely emotional response to the news. The risk may or may not be higher only time and the markets will tell. And another point how can we measure risk? Surely, all measures involve placing subjective (emotional) values to the various inputs?

So, what was the initial market reaction? The dollar and Treasures rallied strongly, while stocks fell hard. Here are three charts showing the market reaction:

The dollar

SB00080-01

US Treasuries

SB00080-01

The S&P 500

SB00080-01

How can we explain such seemingly perverse behaviour (for the dollar and T-Bonds, at least)?

The first thing to say is that when markets behave in such a 'perverse' way, they are trying to tell you something significant. And if you are looking for profitable trades, you'd better be listening!

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Market sentiment is always extreme at major turns

One clue to understanding the reaction (and to pre-empt it) is to follow the internal market make-up.

For instance, I always keep an eye on the various market sentiment readings. When such sentiment becomes too one-sided, I will look for a counter-trend move.

The dollar has been universally unloved for many months. I cannot remember the last time when I read a bullish dollar article! All measures of sentiment I follow are off the scale.

What a terrific example of the herding impulse that I covered in my previous post. Everyone has been on one side of the boat and it almost capsized!

This kind of information alone is very valuable. It has helped me to forecast many market moves correctly. But it is not the only factor I use. The main input to my forecasting is the chart patterns, which is why I spend so much time on them.

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For me, the key to forecasting is to observe what the other participants are doing. And all is revealed in the charts.

It is the very opposite attitude to the normal one of trying to fit the 'fundamentals' into one's own bias, bullish or bearish.

And I have found that the Elliott wave principles are a very useful guide to my forecasting.

In reality, I am able to trade with no knowledge whatever of the news. Of course, I need to know what the herd is thinking about the news, but that is a different matter.

Another point the herd only really coalesces after the trend has been in place for some time.

For me, this is usually the most dangerous time to trade.

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The very best low-risk opportunities come, perversely, at the very beginning of a new trend, when the herd cannot believe what they are seeing, and are scrambling to abandon their trades.

For the herd, confidence levels are at their highest at the major turns, and that is when I like to swoop.

But, as in most things, timing is critical for success, and that is why I spend so much time on this facet.

NB: Don't miss my next trading insight. To receive all my spread betting blog posts by email, as soon as I've written them, just sign up here .

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