The “Action-Reaction” Model: Another Trading Mistake

One of the first things many traders learn when they begin studying technical analysis is that the market moves before the economy. So why is it then, even when traders know this, that when good economic comes out traders assume the market will go up. This is the “action-reaction” model: if good economic news come out the market will go up. If bad economic news come out the market will go down. Have you ever made a trade following a supposedly good economic news announcement, only to watch the market fall instead?

The truth is, the price may sometimes do what we expect when news comes out, and sometimes it won’t. In other words, if you just trade off whether a news release was good or bad, it equates to basically rolling the dice and gambling. It is likely not a sustainable way to extract profit from the market.

The actual market (price) tells us what we need to know. You will notice that when a market, whether it be the stock market or a forex pair, is in a very strong overall decline, people seem to ignore good news. A great report may come out, and the price still drops. That is because the market is the leading indicator, and traders/investors are already letting everyone know what they think — “We need to sell!”

The opposite occurs during a very strong uptrend. As prices are rising strongly, a bad economic report may not even cause a slight pullback. Once again, this is because the market is a leading indicator. Traders and investors are buying, and some report that says what happened a month or two ago isn’t going to sway market participants from buying as much stock as they can.

Now of course there may be immediate volatility surrounding a news release, and it is very common to hear news anchors or even financial analysts rationalize price moves in terms of news. Right after an economic news release you may see a headline state something like “Market falls following disappointing labor data.” But 10 minutes later the market is back up! Trying to rationalize via news releases is not a viable way to trade.

But unfortunately we can’t even say the market always does the opposite of what news would indicate either. Sometimes a market does what you expect off a news release and sometimes it doesn’t. Here is an expert from an article entitled The Stock Market is Not Physics: Part II which looks at this phenomenon.

The four-year period from March 1976 to March 1980 had not a single down quarter of GDP and included the biggest single positive quarter for 20 years on either side. Yet the DJIA lost 25 percent of its value during that period. Had you known the economic figures in advance and believed that financial laws are the same as physical laws [action-reaction], you would have bought stocks in both cases. You would have lost a lot of money.

Or suppose you knew that inflation would triple over the next 20 years. Would you buy gold? Many people believe that an increase in inflation always pushes up gold prices, so the gold acts as an inflation hedge. While this is true sometimes, other times it isn’t. Between 1980 and 2000 gold lost more than half its value while the money supply increased three fold due to inflation. ┬áNews doesn’t predict prices.

The Bottom Line

So why do you need to know this? Because there are a lot of people out there, especially on the news who have never placed a trade in their life, that are going to tell you what to do based on some recent news release. They may not tell you what to do directly, but what they say plants a seed. A headline like “Market drops on lower than expected employment numbers” gives you the idea that next time lower than expected employment data comes out you should sell. But that may not be the case. Trading off news is a crap-shoot, because it is almost always historical in nature, and the market is a leading indicator.

So what is a better way to trade? Avoid the news, don’t listen to it. When you know a news release is coming out, step aside from the market as there is likely to be additional volatility, and weird moves which you can’t predict (based on the people who think they can predict based on news, and are losing money). Then the news release is over, step back in and trade trends based on your technical strategy. In other words, trust price and your charts. They don’t lie, and they tell you all you need to know.