Where Fundamentals Trump Technicals

There can be no better example than the past couple weeks to show how fundamentals can sometimes dominate technicals. With the future of the Euro in question, and worries over global solvency recurring once again, we have seen an unprecedented shift from pure complacency to extreme fear. Mean-reversion certainly loves volatility, but requires that things actually revert to the mean to make a buck! A straight-down drop off down a cliff, and a move in the VIX from 15 to 45 reflects a market that has suddenly changed its mind about the future. It brings to mind analogies (and fond memories) of the morning after a drunken keg party where reality hits you like a ton of bricks along with a headache! Personally I’m not surprised about what is happening—this whole rally has been a giant government sponsored sham to buy time. Finally the tide has run out and Europe is swimming naked (so are the banks but the government has lent them towels). China is showing cracks. When banks were falling in 2008, the world literally quaked in fear. Contemplating the failure of large countries is an entirely different matter. This is where you think about global depression,wars, and revolution.

There are times when the fundamentals are so strong that they trump technical indicators—this seems to be one of those times. During these periods, volatility climbs in a parabolic fashion rather than being cyclic or trending. But the market is pretty quick to adjust, and soon enough even if the trend turns, volatility will be more predictable. The market is a very smart discounting mechanism most of the time but just like the human beings that drive it, the market can fail to see the obvious when optimism or pessimism reaches extremes. It is this regime that is the most dangerous for quantitative models, as it is almost impossible to predict in advance without highly complicated fuzzy logic overlays. I warned on January 30, 2010 on the blog that this year would be full of surprises, and that the US dollar carry trade would cause a dangerous unwinding. I am no longer a fundamental guy, and don’t aspire to return to my old ways, but sometimes a little background knowledge doesn’t hurt. On balance though, I will bet on the predictability of quantitative technical models without hesitation versus an investment campaign dictated completely by my fundamental opinions.