Should you fear that the FED hikes rates?

Tomorrow we will see the end of a two days meeting from the FED. Some indicators seems to show strenght from the US economy such as the unemployment rate and total initial claims who both dropped. Will that be enough for the FED to hike rates?

Highly unlikely in my opinion. 

First, we can question the strenght of the economy. The big boys know this and that's why you hear the media still talking about a "recovery" 6 years after the recession. Some signals are more difficult to decode than others, like the ones sent by the bond market.

"The message from the bond market, supposedly, is that the world today is worse than it was than at any point during the Great Recession, which is nonsense," says Paulsen. 

-Yahoo Finance

Is it really nonsense? No one knows for sure, not even Paulsen. No one really knows what's the extent of the benefits and the dommages of the emergency measures the FED used and is still using.

Secondly, we have to think about the consequences of a rates hike. The US dollar would appreciate against other currencies making it more difficult for foreign investors to invest in the US. On top of the loss markets would inccur directly from the currency, investors would start to quickly get out from the stock market. Like Warren Buffet said: "Interest rates are like gravity for the stock market." The real question is not if people would survive another market crash. The real question is whether or not big businesses and the financial system would be able to absorb the shock. I don't think they would.

Finally, analysts are not expecting a rates hike tomorrow, but rather they want to see if Yellen will take out the word "patient" from her speech. If she does, it would mean a rates hike could be close. However, even if she removes that word, I think we won't see a rates hike this year. That being said, tomorrow could be a bloody day for the stock market if Yellen takes that route.

Banks stress test, stock market, and gold

You probably already heard of the Dodd-Frank Act Stress Test that puts 31 big banks through a crisis scenario. They basically test a wide array of scenarios that goes from a small drop in the stock market to a severe collapse of real estate, the stock market, and main street economy.

Such a scenario would include an unemployment rate of 10%; a 25% decline in home prices; a stock market drop of nearly 60% and "a notable rise in market volatility."   USA today

This test is the first half of the big test (the second one is a qualitative test), and the Federal Reserve concluded that it was a success for all 31 banks. 

All 31 U.S. banks passed a 5 percent minimum hurdle for top-tier capital in an annual health check by the Federal Reserve, the central bank said on Thursday, as the industry continues to rebuild buffers after the crisis. Yahoo Finance

You can access the complete test by clicking here.

Should we be surprised of that good result? I don’t think so. If we look at the chart below, we can see that Reserve Balances with Federal Reserve from banks are at an all time high.

In simple terms, after the crisis the Federal Reserve “printed” the money and sent it to reserve accounts. Banks can then expand the currency supply and create more chequebook money through Fractional Reserve Lending.

This newly created money is supposed to flow into main street economy, but the reality is that it has found its way in majority into some assets such as the stock market. Matter of fact, you can take a look at the velocity of M2 Money Stock on the chart below.

This shows that while banks get healthier and the stock market rises, money is not circulating in the real economy. So I’m not really surprised that banks passed the test with a good score. They have plenty of reserves to support a recession.

The stress tests are so named because they measure whether the banks have enough capital to withstand major economic stressors, such as the 2008 collapse of the housing market. A passing grade means they have enough capital to withstand, say, rising levels of unemployment or plunging commodity prices. - USA Today

Now, the real question that we can ask ourselves is if regular people would pass a stress test. Let’s take a look to Real Median Income to answer the question.

Since the crisis regular people earn less money. But at the same time it looks like they understand the importance of saving money since the crisis as you can see on the chart below.

However, I don’t think the majority of people would pass a stress test. If there was a major crisis, the system and banks would be ok for a certain period of time, but I think regular people would suffer.

Another interesting point is the correlation between Reserves Balances and the S&P500 as you can see on the first chart of this article. It basically shows that if the S&P500 would crash by 60%, banks have a big enough cushion. It also shows that when they’ll start pulling out the money from the stock market there will be a danger for inflation if they inject it in the real economy.

At that step, we may see a rush into gold to protect wealth. But before that turning point, I doubt gold will be traded at August 2012 levels. However, I believe gold will remain of strong value in the meantime.

In conclusion, I don’t think a crisis would crash the whole system and banks like some people say. However, I think it will be a much greater threat to regular people who could see their wealth be wiped out if they don’t protect it.

How to make a trading plan and confirm it’s solid

A solid and realistic trading plan is essential to everyone wishing to be profitable. You should ask yourself many basic questions such as “Why am I trading?” Even if I consider that all the steps are important in building your trading plan, I’m convinced that money management is THE foundation. It’s money management that saved me tons of money by stopping me to do stupid mistakes, like holding a sinking stock for too long.

So how do you build an effective money management plan? You need four parameters:

•        Your starting capital
•        The probability of you winning a trade
•        The percentage of profit you accept before closing a position
•        The percentage of loss you accept before closing a position

Your starting capital is easy to know, it’s simply the money you have available for trading.

The probability of you winning a trade is best determined by your trading history. Simply add up all the trades you did where you made a profit and divide that number by your total amount of trades. You will get a number between 0 and 1, hopefully closer to 1 than 0!

The percentage of profit you accept before closing a position is basically a take profit rule, or a floor on your profit. You could either say “Every time I get to 10% I sell automatically” or “If I get to 10% I’m setting a 10% limit rule.” The same goes for your stop loss.

I programmed a calculator in Excel where you simply have to input those 4 parameters. Then, click “Calculate”. 

Click here to download the calculator

This calculator will calculate your expected profit after 30 samples of 50 trades each. The goal for you is to find the most profitable strategy for yourself.

You don’t really have control on your probability of winning and your starting capital. They are what they are. However, you have complete control on your take profit and your stop loss. I noticed that even if I put so much emphasis on them, many people are just ignoring them. You can’t. You will lose without them, or be lucky and think it’s talent.

Once you have a solid money management plan, 80% of your trading plan is complete.

Don’t try to time the market for profit, simply respect your trading plan.