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Fundamentals Rule, But...
by Darrell Jobman

I’m a diehard technical analyst, but I know that “technicals” do not move the market. Traders may use various technicals to describe or measure or predict price movement in a market, but these technicals are not the underlying root cause for changes in price. The root cause – is just good plain old-fashioned supply and demand. And supply and demand is the basic factor underlying the fundamental approach.

A little review of basic economics will explain the dynamics of price changes. Look at the supply/demand diagram provided below. The supply curve is the arrow that is sloping up and to the right, while the demand curve is the arrow that is sloping down and to the left. The point where they intersect is the fair market price where both buyers and sellers are willing to agree on value. All you have to remember for now is that when either the supply line or the demand line moves, the intersection point, and therefore the price, will change.
image
It is increases or decreases in supply or demand that actually causes the price to move. And when the market price moves, and keeps moving in a certain direction, the result is what we call a trend. If prices continue to rise, we call it uptrend. If prices continue to fall, we call it a downtrend. Trends tend to proliferate more in commodity markets than in equity markets. As a result, trend-following methods tend to work better in commodities and futures than in equities (stocks), although they do sometimes work pretty well in equities too.

Let’s walk through some examples of how markets can change, first from a fundamental perspective, then from a psychological perspective, and finally, from a technical perspective. To begin, let’s look at a few basic laws of supply-and-demand economics:
  • If demand increases while supply stays constant, prices will rise.

  • If demand decreases while supply stay constant, prices will fall.

  • If supply increases while demand stays constant, prices will fall.

  • If supply decreases while demand stays constant, prices will rise.
We’ll start with a physical commodity example, but keep in mind that these same scenarios can also be extended to other physical products, to all financial products such as bonds or currencies and, to a slightly lesser extent, to stocks and even stock indexes.

Let’s begin with coffee. Brazil and other agricultural countries keep growing the crop at a rather steady rate, and most of the rest of the world keeps drinking the stuff on a pretty regular basis as well. Assume that most economic conditions are in equilibrium – that is, the amount of land available to grow crops is all in use, and the technology for producing and harvesting is mature and not undergoing any improvements. Therefore, the supply should be pretty steady and constant, all other things being equal. What will happen to the price as demand changes?

Constant Supply, Increased Demand

What do you think would happen if all of the sudden, research scientists discovered that drinking five cups of coffee a day would greatly reduce the chances of ever getting a heart attack? You can imagine that the demand for coffee, and thus the price of it would go through the roof.

Constant Supply, Decreased Demand

Now look at the other side of the coin. Suppose that after years of research, scientists one day discover that drinking too much coffee increases the chance of getting a heart attack. People are likely to get scared to drink coffee, demand will decrease, and the price of coffee will plunge.

Constant Demand, Decreases Supply

One day a big cold weather front hits the major coffee growing regions in South America, destroying half of the current crop. Now most of us still need our morning coffee to start the day – that is, the demand remains pretty constant or in economists’ terms, inelastic. With the supply reduced all of a sudden, coffee prices are going to go through the roof.

Constant Demand, Increased Supply

Finally, in the last of our four possible market scenarios, demand remains constant but the overall supply increases, perhaps due to some technological innovation that improves harvesting efficiency. The extra supply is more than the market can handle. Coffee merchants are desperate to sell their stores. Prices are sent into a sharp downward trend.

To summarize, as long as supply and demand are reasonably constant and market economics are in equilibrium, the price of any item will remain in a relatively narrow trading range. But once either the supply or the demand (or both) fundamentally changes, even if it is a temporary and not a permanent condition, the price will move out of its old trading range, and the market will seek to find a new level of equilibrium.

This move to a new level can happen quickly or gradually, but most markets tend to move in a building trend as more and more traders recognize the changes in conditions, rather than a move happening in one quantum jump. It is precisely this gradual movement, going through a range of prices, that we call a “trend”.

Four Scenarios, All Markets

If you were to examine the reasons behind large fundamental shifts (permanent or temporary) in supply and demand curves – and, thus, ultimately in market equilibrium – you would find that the answer is usually some large and important event. Different kinds of weather patterns, such as floods or droughts or freezes, can most certainly wreak havoc with the supply side of physical commodity crops such as coffee or soybeans or orange juice. Alternatively, a new scientific health or medical discovery may cause major shifts in the demand side of the equation.

But it’s not just the physical crops, or old-style “commodities” that are subject to these scenarios. They can be extended to all other tradable entities. For example, major political events, such as a war, election, assassination, etc., will undoubtedly have an effect on financial markets such as currencies and interest rates as supply, demand, or both are affected in these markets.

For traders to profit, trending markets are necessary. And as long as we don’t’ have perfect control over the environment and all aspects of our lives, as long as mortal humans are subject to the shims of Mother Nature or political action somewhere in the world, economic shifts will continue to take place and markets will trend. It’s fundamental.

 
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