Since I’ve long been an advocate of the often maligned approach of fundamental analysis, I thought I’d use the recent market volatility to illustrate at least part of my outlook on the subject.
One of the difficulties traders often encounter with fundamental analysis is trying to untangle the various chains of causality that affect the markets they’re trading. A related issue arises in trying to figure out where to stop; i.e. how far back to go. After all, we don’t need to start at the Big Bang every time we think about pork belly futures or the direction of the Yen.
Yet another complication is that not all causal chains have to go linearly back through time. Most economic and financial processes are more cyclical in nature. For example, supply and demand affect price, which in turn has an effect on both supply and demand. In another familiar cycle, the Fed primes the pump, causing economic growth, which then gets out of control and leads to inflation, causing the Fed to raise rates, which slows the economy and leads to recession, so the Fed primes the…well, you get the idea. In one sense, these cyclical causality chains are easier to deal with because, being self contained, they don’t have the open-ended quality that leads to the issue of where to cut off the analysis.
But this is all so abstract. Let’s take a more concrete approach by considering the causes of the rout in the world stock markets at the beginning of this year.
The narrative cited by most analysts I’ve heard includes three major causes for the decline: falling oil prices, the slowdown in China, and finally the Fed’s movement away from easing. There is some truth to all of these, so let’s take a more detailed look at the chains of causality in play.
The fall in oil prices can affect stocks in at least two ways. A direct effect, of course, is that revenues of upstream oil producers is trounced, leading to a decline in that sector as investors expect profits to evaporate. This has a ripple effect as the companies providing services to those drillers discover that their main customer has packed up its wells and gone home.
The second effect is less direct but more pervasive. Models which use the price of oil as an input in order to guage the level of production in the economy will predict a slowdown, and will consequently be flashing sell signals for all cyclical sectors. Sell! Sell, panic, and run I say!
But oil is not the prime mover here. It’s just another trading market like equities, and falling prices in both markets may be just sister symptoms of a larger disease. I call that disease the Great Fall of China (see what I did there?), but we’ll get to that.
First though, while technical factors such as temporary inter-market coupling between oil and equity prices can certainly account for some behavior, what ultimately drives markets is a set of fundamental factors from outside the markets themselves, and even further, from outside the sphere of economics.
Envision three concentric circles. The inner one represents the various trading markets; stocks, fixed income, derivatives, currencies, commodities, whatever. Outside that, the second circle represents the economy (which doesn’t really exist, by the way). This includes production of goods and services, employment, inflation, and other classic macro-economic type processes. The goings-on in both of these two circles are fairly quantifiable. Market prices, volume, and various technical indicators derived from those dominate the inner circle, while economic releases like CPI, GDP, etc. are the points of interest in the second.
But outside those two circles is a third circle that we’ll simply call…reality. This is the world of people with all their conflicts, wars, political intrigues, problems, pasttimes, and whatnot. It’s the physical world with its unpredictable weather and its natural disasters. It’s the intellectual world with its competing philosophies, scientific research, literature, new ideas, and technological breakthroughs.
So using this framework to continue our analysis of the latest market rout, we see that stock prices and oil prices are in the domain of that inner trading markets circle. So we need to look beyond those to the economic sphere. This brings us to the subjects of recent actions by the U.S. Federal Reserve and the economic slowdown in China along with its ramifications for world economic growth.
The causal links from these economic factors to our inner circle markets is pretty straightforward. The cessation of quantative easing by the Fed removes a big source of stock market demand. All that new money in the economy, which the Fed hoped would be loaned out, was actually just parked in assets instead, creating the multi-year bull phase we’ve seen. Also, the recent decision to bump interest rates up sends a signal to the market that businesses may soon find it more costly to raise capital, never a happy prospect for the equity markets.
Turning to China, the slowdown there means that a big source of demand for goods and services from around the globe, including oil, is drying up. So this clearly has the same effect on both the commodities and equity markets; look out below!
So we can see how economic factors from our second circle apply pressure to our markets in the innermost circle. But this just pushes our causality questions back one step. So why is the Fed doing what it’s doing? And what’s causing the economic slowdown in China? Knowing the answers to questions like that is what can enable a fundamental analyist to get ahead of the news curve and anticipate longer term trends. This is where we have to look at that outermost circle. Time to get real.
But this post is long enough already, so I’ll be attacking those questions in more detail in the coming days and weeks. For now I’ll just summarize. The third circle includes things like public policy, regional conflicts, economic philosophies, and changes in technology. In the case of the Fed, its policy of easing was doomed to fail because it was undertaken in the context of an administration that is fraught with flawed ideas of what makes the economy tick. The downturn in China has very similar origins having to do with the policies of the Xi Jinping regime.
Finally, while we’ve discussed oil prices in terms of demand, there’s a supply component too. This can also be explained by factors from our outermost circle. The first factor is technological, namely the fracking revolution in the U.S. Secondly, we have a decision by the Saudis to keep the oil taps open full blast. Why? One possible reason is that they’re attempting to harm Russia economically. Again, more on that in future posts.
So anyway, hopefully this example illuminates one of the major conceptual frameworks that I use for fundamental analyis. To understand what the markets are doing, we have to understand what the economy is doing. But to understand what the economy is doing, we have to understand and keep track of what’s going on in the real world around us. Who’s in charge? What is their philosophy? What are their policies? Who’s fighting whom? And so on.
Until next time…keep pipping up!by