Recent Sell Off

Any marksman will tell you that trying to hit a moving target is difficult enough, trying to predict where that target is likely to be sometime in the future and then hit it with accuracy is bordering on the realms of impossibility. Likewise, predicting accurate future price movements in the financial markets is equally challenging, although some traders have a better success rate at doing it than others.

With a sell off last week in the equity markets participants are now calling for declines from anywhere between 10 to 20 percent from its recent peak. A less conservative view is that a correction of even 50 percent could be on the cards, breaching all support levels.

So are we entering a new market cycle and if so how far could the equity markets really fall?

If we call up a stock market indices chart, between a given time period such as a day, month or a year, we notice that prices move in a kind of roller coaster patten, they go up and then down and vice-versa, you rarely see prices descend in a vertical straight line, not even in a sharp bear market. Similarly, even when markets are hugely optimistic, like in a bull run prices move up sharply, then they pause, maybe fall a little and then continue their upward trajectory. But in both instances prices are not moving upwards, or downwards in a vertical strait line. Prices tend to move in a roller coaster pattern.

By analysing the FTSE 100 index chart, over a given period we can then plot a diagonal line between two or more price pivot points, this is called a trend line and it is used by traders to help them determine future price movements.

If we call up a FTSE 100 index price chart over the last five and half years we notice that the trend line has been moving upwards. During this period there were a number of falls, but they were less steeper and shorter in duration compared to the rises. This is basically the definition of a secular bull market cycle, where the market trajectory is upwards, with a few smaller falls (bear markets) in-between.

These roller coaster rides are often the result of fundamental reasons, such as economic dater, or company results or alternatively what major participants in the markets say or do.

But it’s the latter that’s had most influence in the market’s trajectory, particularly over the last year. Take a look at FTSE 100 index over the last year, this also applies to other stock market indices. What we can see is that every time the markets look like they’re about to go into free fall, breaching all support levels something happens, the bull's best friend comes to the rescue. The central bank responds with it’s governor either saying or doing something to stabilise the market. That shouldn't really surprise us, after all one of the main functions of a central bank is to maintain financial stability. We also know that the central banks are major players, their actions move markets, In a crash scenario typically central banks move in, they lower interest rates or as we discovered recently even buy equities to prop up the market up.

If you were to analyse a FTSE 100 chart over the past 18 months, you will have noticed that every sharp upturn in the market has been the result of central bank intervention. When the market looked like it was about to tank and it seemed like a sure one way bet for traders, the central bank responded with quantitative easing. What was the markets response? It turned sharply upwards. This is pretty much how the market has played out to date.

So the real question that traders should be asking themselves is not necessarily how low the market will fall, but how will the central bank respond to a market in free fall and trade on the basis of that.

This trading strategy is known as the central bank call trade and it has banked traders in excess of 13 percent returns in 2013. These traders wait for the market to fall below a certain support levels, they then anticipated central bank intervention, either equity purchases or quantitative easing to lower interest rates, which has happened without fail over the last 18 months, the market then takes a sharp upturn and continues along its upward trajectory.

So trading on the anticipation on central bank response is a more prudent way to play the markets.

The buying at the dips strategy during this market cycle has been a profitable play. But just because a trading strategy worked in the past doesn't necessarily mean that it will also work in the future. This may be the case if we are seeing the end of this five and a half year secular bull market in equities. Moreover, the average life cycle of a long term secular bull market is about five years, so we may be entering a new market cycle.