Q. Dear Josh, why is a huge budget deficit a problem for the equity markets?
A. Spiralling deficits from several countries within the Eurozone and the UK have been one of the main drivers of equity weakness over the past few weeks. Stock traders tend to think about what is coming next rather than what is happening at the moment, so they are weighing up the consequences of fiscal tightening.
We have already seen governments across Europe, including those of Greece, Spain and Portugal, announce steep fiscal cuts to rein in their spiralling deficits. And there is speculation in the UK that the new coalition government could announce hikes in Vat as well as capital gains tax.
In this scenario, we are likely to see higher prices for goods and services thanks to a higher rate of Vat and our discretionary income will also be cut back.
And if we are spending less, then companies that depend on consumers such as retailers simply don’t make as much money and this could ultimately derail the economic recovery. You can see why the deficit problems have been – and are likely to remain – such a sensitive issue.
Q. Dear Josh, with the recent return of volatility, can stop losses be problematic in these conditions?
A. This is such an interesting question because the very purpose of a guaranteed stop loss is to manage your risk and ensure that you don’t lose more funds than you are willing to risk. However, during extreme bouts of volatility, there is every chance that a market could slump 1 per cent, stopping your position out on the way, only to rally 2 per cent the next day.
The trading session on the Dow Jones of 6 May is a great example of this – it crashed 700 points in a matter of minutes, only to regain most of this by the end of the session. So you can see why guaranteed stop losses may not be as efficient as you would hope in volatile markets.
That said, the reason why you use a guaranteed stop loss is to remove that doubt. You know that if you place a stop on the FTSE at 5,200 your position will be closed to prevent you from incurring further losses should the FTSE trade below this level.
In any market, you must accept that there is always the potential for your trade to be stopped out just before prices reverse. However, there is an important flip side to this scenario. There is every chance that once a market triggers a stop loss, it could keep going against you and without the guaranteed stop loss you would suffer an even greater loss.
Hindsight can be valuable in teaching you where you went wrong and what to change in the future. Assess the positives and negatives of using a guaranteed stop loss before placing your trade.