Tuesday, August 12, 2008

What Recent Market Movements Teach Us About Financial Markets

The recent dramatic market movements with a rising U.S. dollar and falling commodity prices teaches us quite a bit about how financial markets function, some of which I hinted in my recent analysis of these movements.

One is the seemingly odd fact that in financial markets, lower prices can actually increase supply and decrease demand, and so further lower prices in a price-lowering spiral. The reason is that first of all, this decline could make people believe that the particular asset is in a downward trend. Whether this downward trend is because of a perceived shift in fundamentals or a change in market psychology makes little difference. At any rate, it will cause people to sell (or abstain from buying).

Similarly on the upside, rising prices can attract new buyers and discourage people from selling if these price increases convince people of the existence of a new upward trend, a bull market in that particular asset class.

Further contributing to this phenomenon is the existence of "stop-loss" investment rules for fund managers and other investors. These rules compel investors who follow them to sell a particular asset if it falls to a pre-determined level. While these rules may perhaps from a risk-minimizing point of view for fund managers have some justification, it creates the seemingly perverse effect that lower prices will cause people to sell.

Of course, anyone who after all have decided to sell or buy will at any point prefer to sell to the highest currently available bidder and buy from the seller who offers the lowest price, so the normal market clearing mechanism still exists. Instead, the implication of this is that market prices will swing more than what will be justified based on information of fundamental factors, which in turn implies that under- and overvaluations will appear.

The second lesson relates to the existence of quant traders, as well as others, that trade on the basis of various historical relationships. Case in point is the relationship between the dollar and oil. On a fundamental basis, for reasons explained here, an "autonomous" increase in the dollar should lower the dollar oil price, but by less than the increase in the dollar. However, I've noticed that quite often, oil prices increase or decrease more than the change in the value of the dollar in response to sudden swings in the dollar's value. Case in point was the 4% drop in oil last Friday (August 8) when oil fell 4% in just one day. As there was no other market affecting news that day (There was of course the start of the war between Russia and Georgia, but to the extent that would affect the price it would be to increase, not decrease, it) it would seem that the entire decline can be attributed to the dollar rally. Thus, the opinion I criticized here is likely in fact true in a short-term technical perspective. The reason for this is most likely that many traders react to exchange rate movements by buying (if the dollar falls) or selling (if the dollar rise), something which is done to such a large extent that oil change by a factor of more than one, even though it should rise by a factor of less than one.

As was explained here, such mispricing will not hold unless by chance the fundamentals change in a way which justifies the price change. The result of a too high or too low oil price will be increases or declines in inventory levels, which is ultimately unsustainable and result in a return to price levels motivated by fundamentals, including the effect on fundamentals caused by exchange rate movements (which again is a change in the dollar price of oil in the opposite direction of the dollar's value, but by a factor of less than one).

The implication of this is also to create temporary under- and overvaluations because of technical factors.

What we are seeing here are examples of why markets aren't efficient. That in turn implies both a role for technical analysis to analyze these behavioral patterns (which methods of technical analysis is a separate issue) and fundamental analysis to identify which asset values are temporarily depressed (or inflated) because of these behavioral patterns and are therefore likely to eventually soar (or plummet) in value.


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