Last week we talked about how we can prevent ourselves from going down to the abyss of bad trading by examing our trading patterns and more importantly our adherence to our trading process. There were real strategies in last weeks blog that can help a trader pull out of a funk and help steer the trading ship towards profitability. The question remains, did you heed the call? Even if you find this a bit arbitrary at this point in your trading career you may find down the road that this review can set you back on track or at least point you in the other direction. It brings to mind an old saying…what does one do if you find yourself in a hole…first, stop digging! That was the intent of the blog last week was to be able to recognize when we need to stop digging and get a change of direction.

Last week the blog was about awareness. The awareness to know when you are in trouble from a trading standpoint or at least the hint that something may be amiss. This week we are going to focus on a different kind of awareness. This week is all about being aware of the market conditions and situations that are acting around us and what we need to be aware of and the appropriate response to those conditions.

I am going down this road in the blog this week because of an event that occurred last week that requires at least a tertiary awareness so that this little known event doesn’t come back to bite us at some point down the road. The event I am referring to is the inverting of the yield curve. If you are new to this concept and have not heard of it before, don’t feel bad, I would guess you may be in the majority of people. Also, if you have heard about this before but have little to no idea what it means, then also do not feel bad, because I would bet that would also be a majority. Now, if you are a bonafide expert on this subject then this might be a very high level review for you and I would encourage all to read on.

Let’s start with an explanation of what the yield curve is and what it means to traders and regular people alike. The yield curve is referring to interest rate or better known as the yield of a particular bond over a certain period of time. We have bonds that are as short as 3 months in time before maturity and we have 30-year bonds as well. A healthy yield curve means that the shorter-dated bonds would yield less than the longer-dated bonds. This makes a lot of sense for a number of reasons but let me break it down into the long and the short of it. Here goes, if you were willing to lend money to someone for a short period of time you would expect a certain return on your money, yes? Now, if that same person wanted to borrow money for 30 years versus 2 years then you would naturally want a better return, yes? Think of it this way, if you lent money out and got a 5% return for one year then you would most likely demand a higher rate for lending that money for 2 years or more. This only seems logical right? Well, there are times in the markets where logic goes right out the window. In walks the inverted yield curve.

So the next natural question is why should we care about the inverting of the yield curve or for that matter the change in any somewhat normal conditions. Well, we are traders and we are always lookings at conditions and situations that can give us an edge. This is why we study all those patterns, trends, etc. Now, if your a regular Joe the yield curve may not mean that much to you but maybe it should because what this inversion can signify is that the overall economy may be changing. You see the inverted yield curve is a peek in the crystal ball that is the economy and this event has signaled the start of recessions before and it would make sense that this could signal the start of a new recession. Now, does this mean we run out and start hoarding things or dump all of our positions in the markets or run away from the market boogeyman? No, that is not what it means. What it means is that things are changing and that if we are prudent at looking at our surroundings that maybe we can be prepared for those changes and either stave off some damage from the change or even prosper from said change, now that sounds like fun right?

If one were to look at the inverted yield curve that happened before the last two market crashes, in the year 2000 and 2008, one might come to the conclusion that this is a good predictor of a market crash and one would be very wrong if one came to that conclusion. As with anything in life, a single event seldom causes catastrophic change and in fact, it is a multiple of events in succession that typically occurs before the big change. An avalanche comes to mind, think about it, we need a lot of snow and certain temperature changes and then some kind of catalyst to break loose the snow. This is an example of several events that lead up to the avalanche. The markets breaking are very much the same, just because the yield curve inverted doesn’t mean the market is going straight down as one can see this week. The yield curve inverted last week yet the market is soaring this week. So if this has occurred and it has, what other items do we need to be AWARE of to get a glimpse into that crystal ball I spoke of?

Well, the last two crashes that I referred to had several different things that occurred before the market melted down. The first heads up was the inverted yield curve, then some time passed and we saw what a lot of traders are looking for to go short and that was a double top in the big index, the S&P 500. Is this still enough to get short? Well, for some yes but for others no. The more conservative route was to watch for the crossover of the moving averages. This crossover of a shorter timeframe over a longer timeframe is a confirmation signal that the direction of a market or equity has changed. If you saw all three of these occur and you were AWARE of these conditions then you could have put yourself in a position to either protect yourself and your portfolio from damage or dare I say you may even have prospered from this awareness.

Now, that you are acutely aware of this situation, next week in the blog we will go over the scenarios I described above in the actual charts and use some tools to increase our awareness of these kinds of things. So, keep your eyes on the charts and if you see a double top in the big index then make sure you take note of it and watch for any other clues that change has come. This will be your awakeing and then you will be truly AWARE!

Trade well all,
Coach Holmes