“Markets discount everything”, a saying that means a lot and means nothing. Let’s analyze in detail what it means
This is one of the many "sayings" of trading, namely the one related to the fact that the "markets discount everything". But what does it mean? In reality, phrases and sayings in trading are never precise and they mean absolutely nothing if not contextualized within a macro and technical reading which should in fact confirm what is said. Sometimes these sayings are used improperly to corroborate theses on the emotional level of the markets, like “ the markets have already priced in this event”.
But with what presumption can we say that markets have already discounted an event? What certainties do we have and what elements are there to say that the markets have discounted a given macroeconomic condition? Apart from the improper use of this saying, let’s see the reasons why this is said, but above all let’s see the principles of trading and investments that lie behind some mottos like this.
Are the markets ahead or is the economy lagging behind?
To better understand the reliability of certain utterances regarding trading and investments, we need to understand well how a financial market works and how this has influence within an economy. Let’s start from the fact that the current economic system moves in an inter-temporal perspective, i.e. we decide today what we want to do in order to see its fruits in the future or in a precise time frame.
This principle is the basis of the inflation and investment mechanism, i.e. what is worth 1 today could be worth 1 minus inflation tomorrow. For this reason, to avoid the negative effect of inflation on our capital, we resort to investments which usually, to be defined as truly efficient, must cover at least the amount of inflation.
It follows that a good investment is one that offers an “interest rate” higher than inflation. Well, this is the basic principle on which our economy of consumption, savings and investment is based. Basically we move on the financial market today to have future effects within the real economy, therefore the markets do not anticipate and the economy is not lagging behind, but they are two coexisting worlds that move in time different.
From here arise various rumors such as "the markets move earlier", "the markets move earlier", "the markets discount everything" etc. In reality, the markets move at their own pace and the effects on the economy will inevitably occur in the future, because this is how the system in which we live works. We must also consider the fact that the decisions taken on the markets must have an effect on the economy, precisely in order to make adjustments to the balance of the latter.
A blatant example is that relating to the current situation where we act financially with interest rates to have effects on the economy, such as, for example, the drop in inflation, necessary to avoid future impoverishment as explained just now. Basically, the markets see the economy and based on the performance of the latter, decisions are made to improve it in the near future in order to make other and better decisions that always go against the monster represented by inflation and the its burden in the long run. Markets and the economy coexist within a system where one influences the other and vice versa.
Therefore, there are phases in which the market undergoes the economy, in the sense that the decisions taken on the markets serve to regulate the economy, while sometimes they are the markets that dominate the economy with financially destabilizing decisions (see Lehman Brothers crash and rates in 2007-2008).
"Prices discount everything" and the Dow theory
This principle is based on the Dow’s Theory, one of the first technical analysts ever in the history of financial markets. According to Dow, prices already incorporate all the information present on the market, be it information of a macroeconomic, political or technical nature. Here too, theoretically we are faced with a strong, fascinating statement that transmits a certain certainty, a fundamental element within a system in which everything seems random and uncertain. The same strength is demonstrated by “the markets discount everything”, a statement that gives authority to whoever says it but which basically, analyzing it carefully, has no foundation.
Basically prices move because there is supply and demand for a given asset, therefore prices move solely on the basis of supply and demand imbalances, nothing more, nothing less. There is nothing truer than what has been said now, very simple and in fact the only truth for which prices move.
What do the markets discount?
Another question about this externalization is related to events that are theoretically discounted by the market. Within the financial markets, especially at the macroeconomic level, scenarios are hypothesized and within them, events are hypothesized which should be taken into consideration when a given condition occurs.
For example, a strong appreciation of the dollar against the yen up to a certain threshold would lead the Japanese central bank to intervene in the market. Well, this was an example of a macroeconomic event analysis, where a scenario is assumed to occur when a specific condition occurs (strong appreciation of the dollar). In this context, what condition did the strong appreciation of the dollar against the yen discount? Or, when markets suddenly collapse, what do they discount? When markets rise for no apparent reason? As we can see, it is often said that the markets discount everything but we don’t know how to give an answer to what "everything" is.
What to do then?
Quite simply, these useless rumors must be left alone and they only serve to arouse a sense of false security, a sort of relief for a condition that one cannot adequately read. As mentioned at the beginning of the article, the job of a trader and an investor is primarily understanding which component of the system has the most weight at a given moment, whether the economy or the markets, and then establishing whether they will be the markets having to run for cover or whether it will be the economy that will drag the markets in a specific direction.
Furthermore, always try to see things as they are, ie if the markets rise when there are bad economic forecasts (such as now), we must think that there is an excess of demand compared to supply, nothing more, nothing less. Hypothesizing macroeconomic scenarios is essential, especially for an investor or trader, to understand any movements of a specific asset, therefore it is good to focus essentially on these elements, i.e. observing prices and contextualizing them within the macroeconomic environment, perhaps within a scenario assumed a priori.
Basically, letting go of these sayings and seeing the reality of what happens is the only thing to do in an uncertain scenario like that of the financial markets, a world where uncertainty is the only sure thing.
Original article published on Money.it Italy 2023-01-27 08:57:00. Original title: Trading, cosa vuol dire che “i mercati scontano tutto”