Trends are what allow traders and investors to capture profits. Whether on a short- or long-term time frame, in an overall trending market, or in a rangebound environment, the flow from one price to another is what creates profits and losses. Four major factors cause both long-term trends and short-term fluctuations.
These factors are government, international transactions, speculation and expectation, and supply and demand.
KEY TAKEAWAYS
- Economic activity can influence market trends, for the better or the worse.
- Government policy and geopolitical events are factors that can lead to either stability or instability in markets.
- Market participant expectations and the natural balance of supply and demand are other important factors.
Major Market Forces
Learning how these major factors shape trends over the long term can provide insight into how future trends may occur. Here are the four major factors:
Government
The government holds much sway over the free markets. The fiscal and monetary policies that governments and their central banks put in place have a profound effect on the financial marketplace. By increasing and decreasing interest rates, the U.S. Federal Reserve can effectively slow or attempt to speed up growth within the country. This is called monetary policy.
If government spending increases or contracts, this is known as fiscal policy and can be used to help ease unemployment and/or stabilize prices.
By raising or lowering taxes, altering interest rates, and influencing the amount of dollars available on the open market, governments can change how much investment flows into and out of the country.
International Transactions
The flow of funds between countries affects the strength of a country’s economy and its currency. The more money that is leaving a country, the weaker the country’s economy and currency.3 Countries that predominantly export, whether physical goods or services are continually bringing money into their countries. This money can then be reinvested and can stimulate the financial markets within those countries.
Speculation and Expectation
Speculation and expectation are integral parts of the financial system. Consumers, investors, and politicians all hold different views about where they think the economy will go in the future, and that affects how they act today. The expectation of future action is dependent on current acts and shapes both current and future trends. Sentiment indicators are commonly used to gauge how certain groups are feeling about the current economy. Analysis of these indicators as well as other forms of fundamental and technical analysis can create a bias or expectation of future price rates and trend direction.
Supply and Demand
Supply and demand for products, services, currencies, and other investments create a push-pull dynamic in prices. Prices and rates change as supply or demand changes. If something is in demand and supply begins to shrink, prices will rise. If supply increases beyond current demand, prices will fall. If supply is relatively stable, prices can fluctuate higher and lower as demand increases or decreases.
A Mix of Factors
These factors can cause both short- and long-term fluctuations in the market, but it is also important to understand how all these elements come together to create trends. While all of these major factors are categorically different, they are closely linked to one another. Government mandates can affect international transactions, which play a role in speculation, and changes in supply and demand can play a role in each of these other factors.
Government news releases, such as proposed changes in spending or tax policy, as well as Federal Reserve decisions to change or maintain interest rates, can also have a dramatic effect on long-term trends. The lowering of interest rates and taxes can encourage spending and economic growth. This in turn tends to push market prices higher. However, the market does not always respond in this way because other factors may also be at play. Higher interest rates and taxes, for example, can deter spending and result in a contraction or a long-term fall in market prices.
In the short term, these news releases can cause large price swings as traders and investors buy and sell in response to the information. Increased action around these announcements can create short-term trends, while longer-term trends may develop as investors fully grasp and absorb what the impact of the information means for the markets.
The International Effect
International transactions, the balance of payments between countries, and economic strength are harder to gauge daily, but they also play a major role in longer-term trends in many markets.4 The currency markets are a gauge of how well one country’s currency, and by extension, its economy, are doing relative to others. High demand for a currency means that currency will rise relative to other currencies.
The value of a country’s currency can also play a role in how other markets will do within that country. If a country’s currency is weak, this will deter investment in that country, as potential profits will be eroded by the weak currency.
The Participant Effect
The analysis and resultant positions taken by traders and investors based on the information they receive about government policy and international transactions create speculation as to where prices will move. When enough people agree on one direction, the market enters into a trend that could sustain itself for many years.
Trends are also perpetuated by market participants who were wrong in their analysis. When they are forced to exit their losing trades, it pushes prices further in the current direction. As more investors climb aboard to profit from a trend, the market becomes saturated and the trend reverses, at least temporarily.5
The Supply and Demand Effect
Supply and demand affect individuals, companies, and the financial markets as a whole. In some markets, such as commodities, supply is determined by a physical product. Supply and demand for oil are constantly changing, adjusting the price a market participant is willing to pay for oil today and in the future.
As supply dwindles or demand increases, a long-term rise in oil prices can occur as market participants outbid one another to attain a seemingly finite supply of the commodity. Suppliers want a higher price for what they have and higher demand pushes the price that buyers are willing to pay.
The financial markets have a similar dynamic. Stocks fluctuate on a short and long-term scale, creating trends. The threat of supply drying up at current prices forces buyers to buy at higher and higher prices, creating large price increases. If a large group of sellers were to enter the market, this would increase the supply of stock available and would likely push prices lower. This occurs in all time frames.
Why Do Traders Care About Trends?
Trends, either up or down, reflect momentum in the price of a market or security. Many investors and traders try to identify trends so that they can buy when markets rise and sell when they fall. Identifying trend reversals is key for exiting trend trades.
What Technical Indicators Can Spot Trends?
Trends can be identified by using technical analysis indicators using price charts. Several indicators exist, many of which make use of moving averages and oscillators. When prices stay above a moving average or within oscillator bands, markets are trending. When they cross moving averages or breakthrough bands, a reversal is often imminent.
Why Are Bull Trends More Prevalent than Bear Trends Over Time?
Most investments have positive expected returns due to capital being deployed to generate cash flows or value appreciation over time. As a result, the natural tendency is for investment markets to trend upward. However, downtrends can emerge due to changes in the geopolitical landscape or a turn toward recession in the broader economy, both of which can dash growth estimates.
The Bottom Line
As stated above, trends are generally created by four major factors: government, international transactions, speculation/expectation, and supply and demand. These areas are all linked as expected future conditions shape current decisions and those current decisions shape current trends. The government affects trends mainly through monetary and fiscal policy. These policies affect international transactions which in turn affect economic strength. Speculation and expectation drive prices based on what future prices might be. Finally, changes in supply and demand create trends as market participants fight for the best price.