The “Dominant Fundamental Theory” Explained

[I am preparing for a two week vacation in Minnesota to visit my grand kids. I may post a view misc. items this weekend, but I doubt I will post much, if anything, during my trip. I will, however, post a few charts on Chart.ly.]

This past week I read a blog post that nearly knocked my socks off. It was a huge déjà vu moment. It was one of the best postings I have read in years.

Each morning I briefly cruise through the posts made the previous day by the StockTwits blogging community, plus a half dozen other blogs I really like.

For the most part the verb “cruise” is very accurate. I am a very selected consumer of the opinions of others. I have little time for a regurgitation of the news of the day. I mainly look for original research, sophisticated insight into risk management protocols, bold and original thinking and unique market perspectives.

This past week one post led me to a post from October 2010 that knocked my socks off. It was profound. Let me explain.

On Thursday I read a blog post by @EddyElfenbein (Crossing Wall Street), titled Updating the Gold Model . BTW, Crossing Wall Street is one of my favorite blogs. However, this was not the post that captivated me. But, this post led me to a post from October 6, 2010 by Eddy, titled, “A possible model for the price of gold“.

In the October 2010 post Eddy presents a model for Gold pricing based solely on the real (inflation adjusted) short-term interest rates in the Western World, primarily in the U.S. This model has very accurately predicted the fabulous advance in Gold prices during 2011.

But, the accuracy of the model in predicting Gold prices is just part of the story — and quite frankly, where the story becomes interesting.

When I was at the Chicago Board of Trade in the 1970s and early 1980s I was befriended (and mentored) by a man name Dan Markey. Dan was a legend. He was a trader for Cargill (speaks for itself) and probably the best trader I have ever met. Dan’s speciality was picking within a week or two and within 5% or so the annual highs and lows in Wheat, Corn, Soybeans and Soybean Oil.

Periodically he would venture a prediction in markets other than row crops. I remember as if it were yesterday a comment he made about Gold on January 21, 1980. He said to me calmly … “Peter, make sure you are out of Gold because the market topped on the open.”  Of course, it took 28 years for the market to make  a new high.

He was uncanny at doing this — I witnessed it year after year after year. Unfortunately, Dan died in the 1990s of a rare illness.

Dan’s focus was a concept he self described as the “Dominant Fundamental Theory (DFT).” In short, here is what Dan believed:

  1. All markets can be understood with History 101, Psychology 101 and Economics 101.
  2. All major price cycles (lasting from months to years) are caused by one, and perhaps two, fundamental factors. These one or two irreducible fundamentals are the drivers of major trends.
  3. All other factors were irrelevant, although some of the other factors cause some zigs and zags in price. But in the end, all these other factors — many of which market participants think are important — are just plain noise.
  4. The dominant fundamental may be among the things the investment community and financial media talk about, but it is not identified as the real driver until very late in a trend. When the dominant fundamental becomes conventional wisdom the trend is close to completion.
  5. A new dominant fundamental will begin driving the market into a new trend to the knowledge of just a select few traders.
  6. Market watchers who create huge complicated scenarios with multiple factors to describe price trends are full of you know what. They all have brown eyes.

[Think about the stock market since March 2009. The dominant fundamental was corporate earnings. A secondary fundamental might have been irresponsible actions by a bunch of incompetents at the Fed. In hindsight, all other factors were just noise. I believe there is a new dominant fundamental factor driving the market now. We will know what is is at a later date.]

Dan’s ability to identify and understand emerging dominant fundamentals were almost magical. Once he became convinced he had correctly identified the new dominant fundamental, he pursued it like a hound dog on a scent.

Now, let me come full circle back to Eddy’s blog post on Gold. Eddy’s Gold pricing model was about Gold prices, to be sure. But, it was also a commentary on the DFT. Eddy’s model identifies the DFT or a proxy measure of the DFT for Gold, and ignores all the other noise.

Ray Dalio uses another DFT to gauge Gold prices. Bridgewater Associates use a model with the ratio of Gold stocks above ground against the world’s reserve currency supply. From this ratio they will judge Gold to be overpriced or under-priced at any point in time. In effect, Dalio has identified what he believes is the dominant fundamental factor for Gold.

Dalio’s and Eddy’s DFTs are close enough to both be right. The point here is that these two simple measures have accurately forecast the bull market in Gold. Every thing else has been noise intended to confuse traders.

As a trader — and be honest about this — do you chase after all sorts of fundamental news in order to either understand the markets or justify your positions. If you do, you are wasting  your time. If this describes you, please know that your constant attempt to “put the pieces together” is wasted effort. Do yourself a favor and find a different hobby.

By the way, this is why I refuse to watch CNBC or anything of the like. One day the market is down because of X. The next day the market is up because of Y. The next day the market is down because it was up too much the day before. What a waste of time and human energy. CNBC is a circus. Dang, there goes my chance of every being invited as a guest!

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Written August 20, 2011

 

 

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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