Most newcomers to investing or trading look for some rational reason for making a decision beyond accepting some hot tip from the internet or the promotional pitch of a marketing guru.
For many, that will mean trying to discover the value in a market by analyzing the factors that go into determining that value. For physical commodities, those factors relate primarily to supply/demand issues. For equities, those factors may include earnings or sales or other insights into the health of a company.
Those factors can be summarized as the “fundamentals” of a market. They change constantly with each new season or report, and the changes are reflected in shifts in prices. In general, fundamentals control the big picture – the overall direction of prices long term – and every investor/trader should be aware of the fundamentals of the market in which they are involved, no matter what style of trading they decide to use.
BALANCING ACT
Fundamental analysis for physical markets comes down to the balance of supply vs. demand, which determines the current value that investors/traders place on that market. Shift one side of the equation one way or the other, and there usually will be a corresponding effect on the other side and on the price of that market.
You have probably heard the market axiom, “The best cure for low prices is low prices” (or replace low prices with high prices). If the price is perceived to be low or below the cost of production, it discourages production, which reduces supply. The smaller supply increases demand for the limited supply, which produces higher prices. That encourages production and larger supply, and the cycle starts all over again. Economics 101.
If only it were that easy to analyze markets . . .
The big questions are, “What is ‘low’?” and “What is ‘high’?” They apply not only to price but also to the level of supply and demand, and the answers may vary with existing conditions.
SUPPLY FACTORS
Supply for renewable agricultural commodities (grains, soybeans, coffee, etc.) includes three items:
o Stocks carried over from the previous period. Price will usually ration usage so there is some amount left over for the next period.
o Domestic production during the current period. In the case of crops, that depends on the area planted, the area harvested and the yield based on weather, crop diseases and other variables.
o Imports, which may or may not be an important supply factor, depending on the market.
All of those supply factors can usually be quantified in periodic government and private reports, although the numbers may not be precise.
DEMAND FACTORS
Demand is somewhat more difficult to quantify. It depends on a buyer’s ability and willingness to pay a given price for the supply available. If a buyer will consume more at that price, demand increases; if a buyer will consume less at that price, demand decreases.
In reality, the term “demand” should be replaced by “usage” or “consumption” or “disappearance.” Demand depends on a number of variables such as disposable income, demographics, competing substitutes, etc., and it is difficult to gauge buyers’ attitudes. Usage, on the other hand, can be estimated with actual numbers.
For non-storable commodities such as livestock, consumption depends on supply. Whatever is produced will be consumed at some price in a use-it-or-lose-it situation.
For other commodities, consumption depends on price – a low price results in higher consumption and lower carryover. When you add in the intangible of demand, consumers with more money to spend may pay a higher price for a commodity but may not be able to increase consumption because supply is limited.
FUNDAMENTAL DILEMMAS
In addition to not confusing demand with consumption, anyone using a fundamental analysis approach should keep several things in mind:
o Most of the numbers reported are estimates. Whether a report is from a private analyst or from a government agency or whether an estimate is for the size of a crop or the number of housing starts or the number of barrels in storage, it usually is impossible to get exact numbers for many markets. But, agree with the numbers or not, government estimates are the “official” figures with which the market must deal until a new report comes along.
o Market conditions change. A fundamental number that may be bullish one year may not be bullish in another year. What is an adequate supply one year may be tight the next. What deviation from “normal” will it take to influence prices?
o Expectations may have more of a bearing on prices than reality. Going into any major report that updates fundamentals, investors/traders have to consider: (1) What do the “experts” expect? (2) Are those expectations already built into the current price? (3) How do the actual numbers compare with expectations? (4) How did the market react to the actual numbers? A report that should be bullish may get a bearish response if it isn’t bullish enough. Or a report that looks bearish may get a positive response because it wasn’t as bad as it could have been.
o Governments, central banks, acts of war, natural disasters and other events can throw a wrench into supply/usage equations and market prices. Government policies can influence or discourage production or consumption, or central bank actions can affect currency values, which are a major pricing factor in many markets. If oil prices get “too low,” OPEC can threaten to reduce output; if U.S. oil or gasoline prices get “too high,” Administration officials may suggest releasing supplies from the Strategic Petroleum Reserve to put a damper on prices. Political manipulation has become a significant fundamental consideration.
WHO CAN COPE?
Although fundamentals ultimately dictate market prices, getting reliable information about all of these fundamental factors and interpreting what they mean requires more time and resources than many investors/traders have. Instead, they believe that all of the fundamentals are reflected in one thing – price – and, as a result, they often turn to technical analysis to make their actual investing/trading decisions.
For specific trading ideas, read our daily Markets section here.
