Emotional Responses are Dangerous in this EnvironmentMarkets across all asset classes hate uncertainty because it causes traders, investors, and all market participants more than a bit of indigestion. Fear and greed are emotions that drive impulsive behaviors. Effective decision-making depends on a rational, logical, and reasonable approach to problem-solving.
The Fed finally addresses inflation
Recessionary risks are rising
Stagflation creates the worst of both worlds
Tools impact the demand side- The supply side is a challenge
Tools and rules for keeping emotions in check during scary times
Reducing impulsive, emotional responses is a lot easier said than done. While it is easy to mitigate emotion during calm periods, they take over and trigger fear or greed-based actions in the heat of the moment.
In mid-May 2022, the markets face a crossroads. The current market correction is a function of rising interest rates, the potential for an economic decline, a rising dollar, the war in Europe, supply chain issues, geopolitical tensions between nuclear powers, and a host of other domestic and foreign factors.
It is now the most critical period in decades to take an emotional inventory that will avoid catastrophic, impulse-based mistakes. Wide price variance in all markets could accelerate, and those with a plan are the most likely to succeed and protect their hard-earned capital.
The Fed finally addresses inflation
The US central bank had an epiphany after mistakenly believing that rising inflationary pressures were “transitory” in 2021. The Fed woke up smelling the blooming inflationary environment late last year when CPI and PPI data showed the economic condition rose to the highest level in over four decades.
At the May 4 meeting, the central bank hiked the Fed Funds Rate by 50 basis points to 75 to 100 basis points. The central bank told markets to expect 25 or 50-basis point hikes at each meeting for the rest of 2022 and into 2023. The Fed also laid out its plans to reduce its swollen balance sheet, allowing government and debt securities to roll off at maturity. While the Fed has switched to a hawkish monetary approach, it remains behind the inflationary curve. Last week, April CPI came in at 8.3% with PPI at 11%, meaning real short-term interest rates remain negative, fueling inflation. While wages are rising, they are lagging behind inflation. Consumers may be earning more but spend even more on goods and services each month.
Recessionary risks are rising
The US first quarter 2022 GDP data showed a 1.4% decline or economic contraction. The war in Russia, sanctions and retaliation, supply chain bottlenecks, deteriorating relations with China, political divisiveness in the US, and many other issues weigh on the US economy. Meanwhile, rising US interest rates have put upward pressure on the US dollar, pushing the dollar index to a multi-year high.
As the chart shows, the dollar index rose to 105.065 last week, a two-decade high. A rising dollar is a function of increasing US rates, but it makes US multinational companies less competitive in foreign markets.
The falling GDP in Q1 2022 increases the threat of a recession, defined as a GDP decline in two successive quarters, putting pressure on the Q2 data this summer.
Stagflation creates the worst of both worlds
Recession and inflation create stagflation, the worst of all worlds for central bankers seeking stable markets and full employment. The most recent economic data has put the US economy on the road towards stagflation as rising prices and a sluggish economy require competing monetary policy tools.
The Fed is addressing inflation with higher interest rates and quantitative tightening, but recession requires stimulus, the opposite of the current hawkish monetary policy path. The central bank must decide on which economic condition threatens the economy more. The Fed seems to have chosen inflation, but it is more than a reluctant choice. Tightening credit treats the inflationary symptoms, but it can exacerbate recessionary pressures as higher rates choke economic growth. Stagflation is an ugly economic beast.
Tools impact the demand side- The supply side is a challenge
Meanwhile, the US and other central banks have deep toolboxes that address demand-side economic issues. While inflation and recession require different tools, the Fed faces other compelling factors from the global economy’s demand side.
The war in Ukraine is distorting prices as sanctions on Russia and Russian retaliation distort commodity prices. Moreover, the “no-limits” alliance between China and Russia creates a geopolitical bifurcation with the US and Europe. With nuclear powers on each side of the ideological divide, economic ramifications impact the economy’s supply side. China is the world’s leading commodity consumer, and Russia is an influential and dominant raw materials producer. Energy and food prices are the battlegrounds.
Central banks have few tools to deal with supply-side shocks and changes, which can create extreme volatility in the prices of goods and services. The Chinese-Russian alliance transforms globalism with a deep divide. Global dependence on Chinese demand and Russian supplies distorts raw material’s supply and demand fundamentals. While the US Fed faces a challenge balancing inflation and the potential for a recession, the supply side issues only complicate the economic landscape, increasing market volatility across all asset classes.
Tools and rules for keeping emotions in check during scary times
The best advice for dealing with anxiety came from US President Franklin Delano Roosevelt, who said, “the only thing to fear is fear itself.” Conquering fear requires a plan that mitigates emotions no matter the market conditions.
The Fed’s toolbox is bare in the current environment, creating a volatile landscape. Chasing inflation and dealing with a recession in the face of supply-side shocks is a potent cocktail for price variance. Investors and traders need to change their orientation to markets to adapt to the current conditions. The following tools and rules can assist in mitigating the human impulses that lead market participants to make significant financial mistakes:
Hedge portfolios using market tools to protect the downside and allow for upside participation. Hedging reduces the impulse to liquidate portfolios because of fear.
Since volatility creates opportunities, approach markets with a clear plan for risk versus reward.
Remember that the market price is always the correct price. A risk-reward plan only works when risk levels are respected. Markets are never wrong, while traders and investors are often wrong.
A long or short position should constantly be monitored at the current price, not the original execution price. Positions are long or short at the last tick.
Adjust risk and reward levels based on current market prices.
Follow trends, not news, “experts,” or pundits. Trends reflect the crowd’s wisdom, and collective wisdom reflects the sentiment that drives prices higher or lower.
Never attempt to pick the top or the bottom in a market, let the price trends do that for you.
The rules are simple, but emotions are tricky. The emotions that trigger impulsive behavior cause market participants to ignore the rules. The critical factor for success in markets is discipline, defined as “the practice of training people to obey rules or a code of behavior, using punishment to correct disobedience.” When it comes to our hard-earned savings and portfolios, the punishment is losses.
Tuck those emotions away and face the volatile market landscape with a plan. Hedge your nest egg, and you will sleep better each night. Remind yourself that fear is the only factor you should fear.
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Trading advice given in this communication, if any, is based on information taken from trades and statistical services and other sources that we believe are reliable. The author does not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects the author’s good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice the author provides will result in profitable trades. There is risk of loss in all futures and options trading. Any investment involves substantial risks, including, but not limited to, pricing volatility , inadequate liquidity, and the potential complete loss of principal. This article does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein, or any security in any jurisdiction in which such an offer would be unlawful under the securities laws of such jurisdiction.
