Market Divergence & Opportunities

05/23/2019 12:39 pm EST

Focus: MARKETS

Landon Whaley

Editor, Gravitational Edge

When the markets failed to respond to market fundamentals a stronger long-term profit opportunity is often created, writes Landon Whaley.

As an investor, one of the most difficult aspects of trading to conquer is the inner psychological attack that occurs when your process isn’t producing profitable trades at its usual clip. For the Gravitational Framework, there are two types of environments when it loses a bit of its edge.

First, a run of mediocre trading results can occur when an economy is undergoing a shift from one Fundamental Gravity environment to another. During this FG hand-off (like runners on a relay team handing the baton off), markets can trade in unpredictable ways until the newer FG firmly takes hold. Luckily, Fundamental Gravities stay in place for months, even years, so we rarely have to endure the market uncertainty that surrounds an FG hand-off.

The second environment where the Gravitational Framework loses some of its juice is when sentiment gets to an extreme and markets disconnect from their underlying Fundamental Gravity. This environment occurs quite frequently in markets but usually doesn’t last longer than six to eight weeks.

Contrary to popular belief, this is not an environment to shrink from but rather one to opportunistically attack. This divergence between Fundamental and Behavioral Gravities is an opportunity to get positioned at prices where the reward-risk is skewed heavily in your favor before that market realigns.

We’ve seen several markets disconnect from the FG environments this year, only to realign (sometimes quite violently) with the prevailing gravitational pull.

Brazilian equities shot out of the gate this year, gaining 19.7% through Jan. 31. Since that four-week divergence, they have re-aligned with the prevailing Winter Fundamental Gravity, given back those gains plus an additional -2.9%.

South Korean equities gained 11% through Jan. 30 and then traded sideways through the beginning of April before making one last run at new 2019 highs. Since peaking on April 17, South Korean equities have declined 14.2% and look horrific. Generally speaking, the longer markets disconnect from their FG, the more violent the price action when they finally realign. In this case, once South Korean equities acknowledged the Winter Fundamental Gravity, the result was a healthy double-digit correction in just 18 trading days.

This type of divergence is not only seen when markets rally in the face of bearish Fundamental Gravities; the opposite occurs as well.

For example, U.S. utilities began 2019 doggy paddling in the same place until Jan. 30. Beginning in February, your grandpa’s stodgy old utility stocks re-aligned with their bullish Fundamental Gravity and rallied10.9% over the next seven weeks.

Since late April, we’ve seen a number of U.S. markets realign with the prevailing Fall Fundamental Gravity here in Q2. The markets we are particularly bearish on right now (financials, basic materials, retailers) have been among the worst performing markets during this latest correction, which is why we jumped all over the opportunity to short these sectors on their weak bounce a couple of days ago.
Markets disconnecting from their Fundamental Gravity is not something to fear, but rather something to embrace. Remember, there is no better opportunity than when the Behavioral Gravity and accompanying price action of a given market diverges from the direction dictated by the Fundamental Gravity of the economy where that market trades.

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