09 September 2010

Currency Texture versus Equity Valuations

When you make make a trade in the spot forex market you buy a relative valuation. That is, EUR/USD expresses a valuation of the euro to the dollar. But what on earth does this mean ? What are you valuing. That is what fundamental analysis seeks to elucidate. The way this blog looks at forex though, one is not looking at currency pairs per se one is looking at an economic reference from information contained in relative measurements.

This means that EUR/USD is a different instrument from GBP/USD, perhaps like stocks in a different sector ? No, more so, because this blog analyzes stocks regardless of what sectors they are in. There is nothing in forex that groups this asset class together, a fundamental by which you can analyze them. That is why technical analysis is so important in forex, but the problem is, what does technical analysis actually measure.

It is an attempt to find memory in the market, but memory structures seem randomly to exist (the underlying computation may not be stochastic though). But why is there no paradigm of fundamentalist analysis ? Cannot one look at growth, relative value of goods, inflation. Well, it is partly the margin, it makes these factors less significant, even if you have the deepest pockets.

Know how you make a trade and it refuses to go your direction and you just wish it would, well that can happen to anybody (a reason to use a stop loss). It is one reason why those who can trade on low margin. But the lower the margin the lower your returns.

If you want high returns you have to trade on higher margin, because currencies do not move that much and they most certainly do move against you, big time. A stock is not eternally seeking a valuation (but it can get pulled along by a market which is to an extent), but a currency is, because it is referencing relative economic events.

The changes in an economy from day to day are tiny, but relative changes magnify this, as do those future projections which are in spot forex as well, both expressed in relative changes in economic policy.

That is another way of expressing what the Fed and ECB have been doing, they are creating that conduit, which expresses a dynamic change in future expectations. That texture is partly what a currency pair is and it comes into play during news, but in ways which are usually hard to predict, probably because of what technical analysis is trying to capture.

So why are GBP/USD and EUR/USD different. Well, they value in different ways. GBP/USD is partly a lingering historical valuation from when the UK was a mighty economy (not so long ago).

It still has enormous power, way beyond its economic prowess (strong though this still is, and it is powerful in important economic ways as well, for example financial services, it can be a great economy again though). But it seems to value a texture as the UK and the US are presently not comparable.

EUR/USD is closer to a comparison of economies, that is why it is so important, it is theoretically clean in its valuation of major structural components of economic dynamics. But right now it values a shifting belief in the value of the EU and the future economic state of the US...texture again. But the hard computational action is in company growth, a true revival of the US economy.

This would reveal the true worth of the US, the true worth of the dollar, not its use as a reserve currency and source and direction for money flow. Can we assume that technical analysis measures different things with different currency pairs. That is possible and it does seem intuitively like this.

Forex is deceptive it seems like you can use the market as an ATM, but you cannot over time. This is because those instruments are built on shifting sands. Equities are built on financial analysis, creative action, and chaotic dynamics to enable growth (in a working market).

There is nothing like this in forex, except at the edges as this blog has examined. But those edges are important for computational action through the market and forex and stocks can in theory be a positive combination, in a working equity market, because of it.

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