The financial press over the last two days have been worried about the dramatic sell off in Sterling ever since the polls published over the weekend suggested that more people would vote for Scottish independence on 18th September.

In truth, the sell-off has taken place in the context of a downtrend following the pound reaching a six-year high against the dollar in July (see the chart below). However, the dramatic nature of the sell off is being interpreted as the markets finally waking up to the possibility of the Union breaking up. Earlier this year, the pro-Unionists had a seemingly massive lead but this has been steadily eroded over time. And now it seems the momentum is with the nationalists.

GBP sells off dramatically on the possibility of independence

Sell off in GBP

 

To anticipate what is going to happen, I look to what the markets are telling me. I learned this from legendary trader, W.D. Gann, in his 1923 book The Truth of the Stock Tape. Gann was not the first market expert to point out that markets seemingly anticipate what is going to happen – the stock tape speaks the truth – nor will he be the last. The trick, as ever, is in understanding how to read the stock tape.

Over my summer holidays, I read an excellent book called War, Wealth and Wisdom by investment guru Barton Biggs. This excellent book – which I highly recommend – demonstrates quite clearly that despite the public news and perception of what was happening during the Second World War, the markets tended to be ahead of events. For example, Biggs points out that London Stock Exchange made its low “for all time” in the summer of 1940 just before the Battle of Britain – despite the fact that Britain’s fortunes in the war got worse during the late 1940s and 1941 (in Europe – things got worse in the Asian theatre of war for a lot longer). Somehow, the markets foresaw that Britain would survive the Battle of Britain and that the US would be drawn into the war – a pivotal moment that helped turn the war. Similarly, the high point for the German stock market was at the time that the advance units of the German Army were approaching Moscow, in December 1941. This was a moment in the war when the Wehrmacht was seen to be unstoppable – but the markets knew better.

Gann was quite clear that to understand what is going on you should look at charts of the market or stocks. When the market makes higher lows on bad news, this is a sign that things are going to get better. Ascendant Strategy uses this technique in our cycles analysis. Similarly when the market makes lower tops on good news, the market is suggesting a negative outlook for the future.

Back to the UK and the Scottish Independence referendum.

While the sell off the pound vs dollar looks serious, judging from a 2 month perspective, from a two year perspective this has been in the context of an up-trend (see the figure below). Sterling bottomed against the dollar last May and July but then was in a strong uptrend until this summer. Within an even longer timeframe – six years, note how the pound has had a series of higher lows even as the UK experienced one of the worst recessions in decades.

Since 2009, lows in the pound vs. the US Dollar have been increasing.

GBP rising lows - economic recovery

 

The market looked past the problems created during the boom of the 2000s and the subsequent bust well before the news turned positive (as it has finally in recent months).

The fall in the pound must be seen in that light. The fall is likely to bring a higher bottom – which suggests that the outlook remains positive. A break up of the Union could be quite negative for sterling, at least in the short-run, so I think this is the market suggesting that there will not be a break up – or that there would be a way through the mess if there were a breakup.

The reason I am looking at the 1.59 level (mentioned in the title) is based on another technique I learned from W.D. Gann. He taught that the 50% point (the mid-point) was an extremely important point which markets find at emotional points. You can use the market’s reaction to this mid-point to anticipate what will happen. The sell off in the pound since July is taking us to one of these mid-points – at the 1.59/1.60 level (see the chart below) measuring from the low in July 2013 to the top in July 2014.

The recent fall in pound brings the market to a mid-point

GBP50 per cent

 

Gann looked at whether the market stayed above or broke through the mid-point to make a forecast of what would happen next. If the market stayed at or above the 50% level, this was a bullish sign. If it broke through this was negative.

So, at an extremely emotional time for the UK, we find ourselves at such a midpoint. If the pound stays above 1.59/1.60, I think this is the market anticipating that the Union will stay intact. If it breaks through I think there may be a vote for independence and/or problems in relation to deciding the future of the currency. Even then, as these debates take place, if the market finds a higher low on difficult news (e.g. fights about sharing the currency, the role of the Bank of England, fiscal rules etc.) this is the market’s way of saying that things will work out.

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