What Shapes Market Trends?

The global financial system is made up of a series of institutions and capital markets that has come to be known informally and collectively among investors as "the market." The market can be understood as the collective global arena for buying and selling financial and physical assets.^[1]

The Ever-Moving Market

While integrally linked to what economists call the "real economy," which represents the sale and purchase of physical goods and services, the market is understood to frequently follow its own unique trends that don't always correlate exactly to the trends of the real economy.

How Are Markets Measured?

Markets are generally described by the median price paid for assets traded in them. The market as a whole, in addition to individual markets, are understood to follow trends that trace patterns oscillating between troughs and peaks of median prices.

There are numerous indices that measure and track movements of groups of assets traded on major financial exchanges. Some of the most famous include the Dow Jones Industrial Average, the Nasdaq Composite and the S&P 500, which generally measure stock prices. Bond price trends can be tracked through indices like Barclays U.S. Aggregate Bond Index or the S&P International Corporate Bond Index.

Commodity price trends can be tracked by indices like the CRB commodities index or the Bureau of Labor Statistics Producer Price Index for Commodities. Currency trends can be tracked through the movements of individual currency pairs, or indices like the U.S. Dollar Index, the JP Morgan Emerging Markets Currency Index or the Federal Reserve's Major Currencies Index.

Where Is It Going?

Financial analysts generally distinguish between "fundamental" indicators and "technical" indicators that determine which directions markets, and the overall market, can follow. As economic trends are ultimately linked to human psychology and the collective sentiment of the people participating in the market, both types of analysis attempt to anticipate people's estimated demand for assets, although through different methods.

Underlying Forces

According to the technique of fundamental analysis, there is a set of indicators for any given market that can be analysed to determine the health of assets and trends for them and the overall market. These are often "macroeconomic indicators" like interest rates, employment, trade, federal budgets and GDP.

Fundamental analysts attempt to understand the "underlying forces" in the market that will push asset prices in a particular direction. For example, when central banks raise interest rates, analysts note that borrowing will become costlier, and consumers and investors will be more hesitant to borrow money to buy goods, services and assets. From this, economists can predict that when interest rates rise, money will flow more slowly throughout the economy and there will be less activity and growth in the market.

Similarly, when GDP growth slows or falls, economists can conclude that investor or consumer sentiment is poor, and that there is a possibility that slowing market activity will become a trend. Beyond whole markets, individual asset classes are usually influenced by their own particular indicators.

The trend for a stock, for example, can be determined by a company's recent earnings results or supply and demand trends in its industry. The trend for currencies can be influenced by factors such as their countries' national balance of payments data, central bank intervention policies, local stock markets or inflation trends.

What The Charts Say

Technical analysis is a strategy based on ideas developed from Dow Theory, a group of principles set forth by Charles Dow, William Hamilton, Robert Rhea, George Schaefer and Richard Russell in the early 20th century. The technique seeks to forecast market movements through examination of historical patterns of moving price and index averages. Technical analysis is underpinned by the efficient market hypothesis or the idea that prices discount for all factors.

Unlike fundamental analysis, technical analysis doesn't attempt to determine why the market will move in a particular direction. It simply attempts to predict what the market could do based upon what it did under similar conditions in the past. In essence, it tries to use the collective knowledge and behaviour of all participants in the market to understand the current trend.

Technical analysts assume that market prices and indices tend to retrace historical patterns. The trend at any particular time can be understood to be self-perpetuating through its "momentum," or be self-limiting. When prices hold within the lower limits of the patterns, the market is said to show "support" that won't allow prices to fall lower. And when they remain within the upper limits, the market is said to show "resistance" to higher price movements. Technical analysts build and analyse charts to try to determine where the market is in its current trend and where it will go next.^[5]

Follow The Money

Of all the markets, the currency market is the largest, with up to US$5 trillion in currency changing hands daily. By contrast, the global bond market moves about US$830 billion, and the stock market moves about US$190 billion.

Among participants affecting market trends are institutional investors like banks, investment funds and multinational corporations. They are also influenced by governments that issue debt and make overseas debt payments and funding transfers.

Finally, there are individual investors who are trading assets and transferring funding on their own behalf. Often, large market movements will be precipitated by large asset purchases or funding transfers by institutional investors or governments. They can also be touched off by collective reaction of institutional or individual investors to encouraging or discouraging economic data or news events.^[6]

Funds moving into a particular asset class will create a sense of optimism and euphoria among investors. This can then generate a further positive sentiment, buying and possibly a "bubble," where prices are understood to have surpassed levels considered reasonable. Similarly, funding moving out of asset classes, like stocks, bonds or currencies, can generate pessimism and cause a self-perpetuating downward trend in the market. In this case, investors retain funding and seek to put it in investments perceived as safe and less volatile, such as savings accounts and precious metals.^[7]

When investors are active in markets, the markets are said to be "liquid," as there is more money flowing in them and much opportunity for trading. When activity slows, markets can become "illiquid," limiting opportunity for trading and making formation of prices difficult for traders.^[8]

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