echnical traders like to think technical analysis is the quan-
tification of market sentiment, which consists of a hodge- podge of fundamental facts, consensus interpretation of those facts, precon- ceptions, misconceptions, prejudice and lies.
Such traders contend it\u2019s not really worth untangling all these fundamen- tal elements because price cuts through all the buzz and clutter, pro- viding the only truth you need to make a trade.
However, traders should not dismiss the study of market fundamentals, because technical analysis alone does- n\u2019t always work. If you\u2019ve used techni- cal indicators for any time at all, you\u2019ve learned no indicator works 100 percent of the time \u2014 in fact, most work less than 50 percent of the time. That does- n\u2019t mean you should discard indica- tors, but itdoes mean you should use multiple tools and money management techniques. Even then, however, you can still get blindsided by a change in market sentiment, which most indica- tors will confirm only with a lag.
What is the structure of market sen- timent and how can you use it to make better technical trading decisions? Equally important, when should you pay the most attention to sentiment?
Regarding timing, it\u2019s never more important to supplement a trading decision with sentiment than when a market is consolidating. Prices are non- trending well over half the time; some analysts put the figure as high as 70 percent. When prices are consolidating, we expect a breakout one way or the
other, but it can be devilishly hard to select the right direction when some indicators are pointing up and others are pointing down. If you understand the components of market sentiment, however, you can judge their effect on the technicals, and often be better pre- pared to jump on the breakout.
Market sentiment is crucial during corrections, too. You never know when a correction will turn into a reversal. At the critical start and end points of a cor- rection, it is almost always a sentiment change based on news that triggers the move. The market often seems to use some factor or another, real or imag- ined, to engineer a correction it wants. Corrections are somehow part of the natural order of markets, so traders must invent excuses to exit positions, whether the story holds water or not. It\u2019s handy to know whether a corrective move is rational and valid, or just an excuse. Analyzing the fundamentals helps make such distinctions.
Market sentiment may seem like a vague concept, but when you take it apart, you see it consists of specific fun- damental and technical components that interact to generate a bias for a cur- rency, either favorable or unfavorable. The bias comes from the overall envi- ronment, and perception of the envi- ronment will color the news.
At any one time, a majority of FX traders agree on the bias even when they disagree on everything else. In terms of the components of the envi- ronment that establish market senti- ment, there are big-picture factors and little-picture factors.
factor in the market environment that establishes sentiment is an economy\u2019s collection of \u201cstructural\u201d conditions.
In the U.S., the most important structural issue is the current account deficit, which will be 5.4 percent of GDP this year and perhaps more \u2014 an unprecedented level in a developed country. Most analysts say this is unsustainable, a conclusion cited for the dollar\u2019s three-year decline that started in July 2001. It was clear even then that once the current account deficit got on the radar screen, it would be very tough to get it off. At the time, the deficit was 3.5 percent of GDP, and it has deteriorated exactly as expected. That\u2019s the whole point of a structural problem \u2014 it\u2019s the elephant in the living room.
Another structural element is the budget deficit \u2014 but it\u2019s a lot weaker, because the free-market character of the overall economy suggests the U.S. can earn its way out of it. Fixing the current account imbalance would require other nations to do things they show no inclination of doing, such as China and other Asian Tigers unpeg- ging their currencies from the dollar and Japan leveling the playing field for U.S. imports.
In Japan, the big structural issues are the too-high savings rate and too- low consumer spending level (twin roadblocks to ending deflation), along with a risk-averse and ailing banking sector that will not lend and allow the multiplier effect to work its magic.
Technical analysis can help clarify market behavior, but it doesn\u2019t do everything \u2014
and it\u2019s not always correct. The forex market also requires traders to understand
the interaction among the various fundamental catalysts.
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