Back to the Future

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Narrative is what people think drives the market. They read the news and think that it tells them that the market went up or down because someone did or said something.

This is very often not true.

People look at stocks and see them rise and fall and imagine it is people that are buying and selling stocks that is moving the price.

This is very often not true.

What is really going on is much more complicated.

All markets are tied together so that someone buying gold in Tokyo will affect someone selling RBS in London. That seems impossible but in today’s markets all instruments are inked together by arbitrage.

Let me explain.

If you look at two big UK companies, you will notice they trade in line with the index. That is because people want to buy the whole FTSE with ETF or futures or options. If the index rises and a company is left behind, it will likely catch up. As such people will buy up that company to bring it in line with the index. So if Shell rockets and drags up the FTSE, it will drag up all the other companies with it.

This behaviour might seem crazy, but the relationship between things is caused by something called correlation. If one bucket of apples goes up in value so will another. They are highly correlated.

By looking at the way the value of two things move you can calculate the correlation between the two things, so that if one moves you can check the new theoretical value of the other. If it’s too cheap you buy it, if it’s too expensive you sell.

Now as everything is linked by one correlation or another, when one thing moves, it moves everything, even if it is an infinitesimal way. In this way the price of Microsoft on NASDAQ affects the price of gas in Russia. Most price moves are not caused by news or people but by this process.

The real question is, what moves what?

So as you watch a stock rise, you might think it is suddenly in favour with the market, but you would be wrong; it might be a correlated stock on another market enjoying good news instead. More importantly, it might just be the stock futures market responding to a change in currency values.

This is key, because in shares, the index futures drive stock prices, not the other way around.

The future prices move and the market buys and sells the actual stocks to make them reflect the movement of the future prices. It is very rarely the other way around.

What is more, the stock index futures are driven by their correlations to currencies, interest rates, bonds and commodities. This means as you watch a share fall or rise heavily it might be absolutely nothing to do with the company’s performance at all. It could be simply the dollar zoomed or crashed or some such apparently irrelevant change. It is the correlations between these financial instruments setting the price not company news.

Happily underneath all this indeterminate noise there is an economic engine at work. A stock is a living thing unlike a commodity or a currency. It should be growing against all short term noise. As such you can sit back and let tiny growth factors trump noise and correlation.

This is why the long term view works better than the short term, because you can almost rely on good companies to grow over the long term, whereas its nearly impossible to tell whether something weird is happening in a market somewhere that through a chain of correlations will affect this hour or day or week.

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