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What Comes Around Goes Around
The Circular Nature of Financial Markets - text
The Circular Nature of Currency Prices
The very first thing to realize about currencies is that current price is nothing more than a suggested value; there is no scientific way of knowing what a currency is actually worth. Economists have put forth theories such as purchasing power parity, however empirical evidence clearly shows that actual currency values seldom trade near these theoretical values.
Economists babble on about GDP, Current Accounts, Trade Balances, Employment and a slew of other comparative measurements but once again the evidence shows that the currency values are almost always at odds with what should be based upon fundamental analysis.
What determines a currencies current value is the collective thinking of the market. The collective thinking of the market is influenced by price. As the value of a currency rises the market enhances its value by anticipating further gains, thereby pushing the currency higher still. As long as the currency continues to rise, the market remains positive on the future performance of the currency and it continues to perform well.
When price declines slightly, the collective thinking of the market does not change right away; however weak longs (traders with highly leveraged positions) are forced to liquidate causing further price decline.
If the price decline persists, market opinion becomes more negative and further price declines result; thereby causing a further shift in market opinion toward negative, which in turn causes further selling and further price fall.
When price begins to go up again, market sentiment changes back to positive and the cycle starts all over again.
This circular cause and effect pattern is always present in the market. Because the collective market is essentially a crowd, the price over time tends to move further and further from what economists determine to be fair value.
Since the current currency price has little to do with “real fundamental value”, traders cannot assume that the release of a particular economic number away from market expectations or a statement by a government official will have a quantifiable effect on the market price.
It would depend upon whether the news or statement changed the collective thinking of the market. The most likely circumstance that would change the markets opinion would be a change in price.
The conclusions to be drawn are as follows:
1. Market opinion causes currency values to overshoot in both directions because it is a crowd mentality.
2. The opinion of the crowd changes often and most often in the direction of price.
3. Trade in the direction price is going and the crowd will not be far behind.
4. Trying to think rationally and going against the crowd is like trying to talk sense to a madman.