A Better View at The Hierarchy of The Financial Markets

After coming across Adam Robinson in the Knowledge Project podcast, and hearing a few commentators talking about the concept of a hierarchy of the capital markets, I thought I would give my views on this and the value it adds to the investment and trading process.

It’s best to start with the way Adam breaks down these groups from the earliest trend spotters to the later adopters:

Metals traders
Bond traders
Equity traders
Oil traders
Currency traders
Economists
Central Banks

In the podcast, Adam references Everett Roger’s work in the study of the Diffusion of Innovations which explores how the adoption of technology spreads. Though you can generalise it on how trends generally spread whether we talk about narratives, fads or even social norms, the possibilities are endless. They can apply to just about any discipline. You could even argue we are in the middle of one of these changes right now during the COVID-19 recession (at the time of writing).

Could the working from home be one perhaps?

Rogers breaks down the categories of adopters as innovators, early adopters, early majority, late majority, and laggards. The standard distribution chart in his study demonstrates this:

The relevance to the capital markets?

Fibonacci users would say it works because the sequence is all around in nature. Well, something else is also in human nature arguably more so than the Fibs, it is so ingrained in us that many disciplines have been trying to understand its mechanisms: groupthink, collective consciousness, herd behaviour, whatever you want to call it that creates the ripple effect.

Market participants instinctively key off one another

Robert Prechter, (the gent who popularised Elliott Wave Theory) explained it beautifully in his book “The Socionomic Theory Of Finance”: that “aggregate investor thought is not conscious reason but unconscious impulsion”; “human herding behaviour results from impulsive mental activity in individuals responding to signals from the behaviour of others”; “The interaction of many minds in a collective setting produces super-organic behaviour that is patterned according to the survival-related functions of the primitive portions of the brain”.

Put another way; the market collective is greater than the sum of its parts, the individual market participants. Its perception is more significant because it encapsulates everyone’s expectations, so it is continuously ready to shift depending on the collective sentiment.

George Soros expressed it best when he said: “reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued.” So as securities (equities, fixed income and FX) are being values, their fundamentals get affected, which changes traders/investors opinions about their prices which creates an endless cycle. It is like the Lucas Critique for the financial markets. Perceptions of what their prices should be. A process that plays out in a never-ending loop!

Going back to Adam Robinson’s interview, you could use his definitions to make sense of the above:

First, “an investment is nothing more than an expression of a view of the future”.

And a “trend is the spread of an idea”.

But this is best illustrated visually with a normal distribution when adapted to Adam’s groups, it looks like this (with my own additions):

What’s the application?

Well, I believe its best to revisit Adam’s words again, namely how he approaches the market where he will “wait for different groups of investors to express different views of the future and to figure out which group is right. [he looks] for differences of opinion strongly expressed, and [he will] decide which one is right.”

He considers Metal Traders the most farsighted and connected to the world economy. It makes sense as metals are real goods and services that are exchanged- in the example Adam used, a copper trader would view more buying of copper as interest rates would go down soon; less copper buying would mean they would go higher.

Next would be Bond Traders. By this model, if they disagree with Equity Traders, 99/100 times they tend to be right and early. The same logic applies with equity and FX, though the edge is not there like bonds-equity, it’s more like 3/4 times. (If you were to implement this to your strategy, you could plug-in the gap, arguably.)

You would assume Metal Traders are always right and believe that FX Traders tend to lead the way for oil traders too. Though he added FX sentiment is reflected in commodity currency crosses (think of the commodity currencies). Economists are always wrong as they are always late, and Central Bankers rely on economists and statistical models.

While Adam made special attention to oil traders, I would like to group Energy Traders there. While oil is a significant contributor, as he pointed out, it’s hard to forecast. I opine that it is sensible to include other energy markets in this group, such as natural gas to get an overall picture of the energy market. I’m not going to detail a strategy on how to track each market, as I’m sure everyone has their own strategies!

The 8th Group

I added in an 8th group, which I believe completes the model and gives it room to fit with other strategies. You could argue these could be governments who know even less than central bankers, yet rely on central bankers work (to some extent). Undoubtedly, we know governments can heavily influence the markets. The 8th group could also include other groups that could disrupt the market. Something that the metal traders could not react to, for example. (Though, you’ll need to use your own discretion on what that is. )

The Importance of "Intermarket Analysis"

This seems to be mostly a dressed-up variation of Intermarket analysis. However, this is more structured in that it attempts to spot trends before they occur by effectively using the metals market as the primary market that underpins all the other markets. In-itself it seems like a smart idea, I personally cannot vouch for this as this is not a strategy I have backtested myself.

However, I would not say the idea of Intermarket analysis is revolutionary or something brand new. This is because there have been a few words, on it (though, not as many as there could be in my opinion) with the most famous one being by “Intermarket Analysis” by John Murphy.

Arguably, Stanley Druckenmiller subscribes to this approach as he said this during a RealVision interview:

One of my strengths over the years was having a deep respect for the markets and using the markets to predict the economy, and particularly using internal groups within the market to make predictions. And I think I was always open-minded enough and had enough humility that if those signals challenged my opinion, I went back to the drawing board and made sure things weren’t changing.

If anything, I would argue that this certainly makes a strong case on how Intermarket analysis has a place in any market strategy.

What are your thoughts about the above? Leave a comment below sharing your ideas with us.

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A Better View at The Hierarchy of The Financial Markets

The relevance to the capital markets?

Market participants instinctively key off one another

What’s the application?

The 8th Group

The Importance of "Intermarket Analysis"

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