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Fundamental analysis in trading system development

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Noticed this post on SeekingAlpha [thankx to forex_gal for the tweet].

This remainded me of my own research done a few years ago. I didn’t know “the he Austrian school of economics that defines inflation as the expansion of money supply”, but my hypothesis were very similar.

My first presumption was that the inflation measure is M3/broad money supply less GDP growth. The idea was that GDP growth increases the need for more money in circulation to service the economy. So, GDP “neutralizes” money supply effect as a inflation-inducing factor.

My second presumption was that higher inflation induces stronger currency. This comes from observation in the currency markets that higher inflation data usually lead to stronger currency. And academic logic should suggest that higher inflation should mean weaker exchange rate as the inflationary currency gets debased by increased money supply (aka money-printing).

The marketplace reality defies academic logic — higher inflation usually means stronger currency (of course, this applies to low-inflation environment only, but not to hyperinflation). There may be a good explanation. Higher interest rates are generally associated with higher inflation, and such interest rates may be a good deal an investors, but a bad deal for domestic population. The catch is that population can not get out of bad deal (higher inflation and interest rates) while trader/investor can switch in an out of the currency instantly. However, in the long run the currency should decline in line with the money supply differential.

The whole methodology is to project money supply differential and plot it against exchange rate. In the long run, the both parameters should converge. In short term the parameters will fluctuate away from equilibrium in one or another direction.

My finding are that the parameters converge fairly consistently for all the major currencies. In Novermber 2007 our reasearch concluded that, according to this methodology, the British pound is overvalued by about 60% and such overvaluation disbalance has been accumulated over about a decade. In Y2008, GBPUSD declined from about 2 to 1.36 at its lowest point.

Can the methodolgy be used for a valid trading system? Hardly. The problem is that even if fundamental analysis correctly determines the magniture of the disbalance, it has no way to tell when such disbalance is going to correct. As in the example above, GBP disbalance accumulated for about a decade before at least partial adjustement took place. As Keynes correctly noted, “market can remain irrational longer than you can remain solvent”.

If you run a multi-billion fund and make massive macro bet on currencies, to have such fundamental analysis for the merit of second or re-inforcing opinion, is a prudent and professional choice. For small traders/funds, it is beyond limit or merit to maintain such fundamental analysis. They are probably better off by just following some trend-following rules. If the price breaks, just go with the trend. More often than not dumb/uninformed trend-following trade will be as good as smart/informed trend-following trade.

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Written by A.S.

June 11, 2009 at 8:43 am

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