Market analysis and forecasting basics
How do traders and investors predict future price trends and market reversals?
People through history have always had this craving and need to have someone tell them about the future. But accurately predicting what will happen in financial markets can be a tough gig and even Wall Street analysts will sometimes admit a misplaced confidence in their market forecasting. Investors like modelling because it appears scientific and gives off a certain arrogance in many ways. Professional traders are more concerned with getting the basics right and trying to predict future price action, through fundamental analysis and technical analysis. Far from random predictions, this can help traders improve their market understanding and knowledge to make better long-term trading decisions.
How to recognise bullish and bearish trends
It is generally recognised that market moves will continue in the same direction. This idea is based on the concept of behavioural finance which can help us understand how traders and investors react in certain circumstances. The key notion for market forecasting is that of herd behaviour which states that people tend to copy the actions of the majority of the herd. This is backed up by numerous studies that tell us that mutual fund inflows are positively correlated with market returns. In simple terms, people invest, the market goes higher and this encourages more investors to buy. Momentum plays a big part in today’s markets too as assets, specifically stocks, are more likely to outperform if they have done well in the prior few months.
Recognising trends is one of the most popular ways of trading, especially as trend following at its best aims to compound absolute returns. Bullish trends show positive momentum as there is a series of higher highs and higher lows in the market. Price corrections are inevitable, but this doesn’t mean the end of a bullish trend, as long as the market forms fresh higher highs. Bearish trends follow a similar pattern but with lower lows and lower highs.
What is Technical Analysis?
If you believe price holds the key to analysing markets, then you will be very comfortable studying charts to identify price patterns. A good chartist optimises success by using historical charts to predict the movement of prices in the future. This study of price has three principles which are at the core of its method of market forecasting:
History repeats itself – chart patterns have been used for over 100 years. The repetitive nature of price movements is attributed to market psychology. These patterns are represented in every chart so are still highly relevant today.
Market action discounts everything – all information, including fundamentals are in the price. Any new data, news or information is immediately reflected in an asset’s price.
Prices move in trends – asset prices tend to move in observable trends. Once a trend is established, future price direction is likely to be in the direction of that trend.
Technical analysis is essentially a study of supply and demand. The graphical representation shows all the greed and fear of traders at a specific time in history which is entirely objective, so it is an excellent gauge of both direction and sentiment. That said, this type of market forecasting is not an exact science which is why it often comes under attack. But especially in the short-term, it is momentum and sentiment that can be the most significant factors in price action. Why and how you choose to use charts will depend on your trading style. So, if patterns and charts appeal to you, technical analysis will be an essential tool in powering up your trading strategy.
What is Fundamental Analysis?
If you much prefer reading about the economy and business, then fundamental analysis is for you. This involves news, macro and microeconomics, political and geopolitical factors; in fact, any factor that can affect the value of a market and an asset. Take for example a forex trader who needs to understand the reason why and how a weaker than expected US non-farm payrolls report will affect the dollar and monetary policy. This analysis may also encompass looking at the make-up of the policymakers at the Federal Reserve, their leanings and voting patterns at their meetings.
Bullish and bearish trends can be determined by a strong understanding of the economy (known as “top-down” analysis) and companies (“bottom-up” analysis) which act as key drivers in markets. Indeed, many associate fundamental analysis with the valuation of a company, its stock and whether it is over or under valued. A whole business is the sum of many parts so analysis of this type involves studying financial statements and earnings. This macro and micro approach may be more conducive to longer-term trading where a trader has a sound fundamental footing of all events.
Evaluating all the factors affecting an asset’s price can certainly give you an edge in your trading. Of course, there are no magic bullets, single piece of news or financial ratio which will tell you to buy or sell. But the picture they paint can give you a deeper understanding when trying to forecast future price trends and turning points.
Should I combine fundamental and technical analysis?
A trader will often need to look at more than one market to build a complete understanding of what they are trading. But ultimately, every market is driven by the simple concept of supply and demand and so it makes complete sense for traders to use a combination of fundamentals and charts to study and forecast markets.
Using both disciplines means you might review price action and trend strength using various technical indicators, but then look at the fundamentals to see if future supply and demand or a potential risk event could move price. For example, a trader knows there is an important Bank of Japan meeting coming up in the next few days. After studying the charts, they see that many Japanese Yen pairs are coiling in a tight range just below resistance levels and showing bullish continuation patterns. Can the trader expect some policy surprise to push the market through these levels and continue moving higher?
The beauty of markets is that every trader will interpret news and charts in different ways. By incorporating your own rule set to make trading decisions, the strengths of both technical analysis and fundamental analysis can be incorporated into your trading decisions Next time you go to buy a stock, why not take some time to look at the long-term stock chart so as to get a picture of the performance history of the trading opportunity you are considering. This may help you refine your entry or exit level.
What is the impact of social media and trending news on markets?
Like many industries, financial markets share information and data via the internet and through social media. You’ll find many traders voicing their views through tweets, blogs, Youtube videos or TikToks. But the fact is that they also consume it, and in the process can be swayed heavily by the sentiment and opinion of others. Scientific studies show that people are often influenced by the data they consume and that their decisions are partly aligned to it. In fact, that is essentially the nature of a trend. People like to be associated with something doing well, with winning stocks gaining an increased following the more they go up in value.
In many ways, a perfect storm has developed between easy access to financial markets, market forecasting and the growing power of influencers, , also referred to as #finfluencers, who can put together a strong enough wave of investors to significantly impact some financial assets. Witness the January 2021 uprising by Reddit users and the huge volatility in retail ‘meme’ stocks like GameStop. In an age of social distancing, a risky but potentially lucrative collective entertainment saw markets driven by the flow of capital rather than any fundamental or technical analysis. These traders didn’t look for bullish or bearish trends and there were no rational calculations about expected future cash flows.
There are numerous examples of the power of social media and news events on financial markets, with extraordinary retail demand sustaining bankrupt companies and pumping up assets with poor fundamentals and cash flows. Of course, no one could predict the impact of these platforms and also what may happen in the future. Perhaps influencers and communities will have some short-term influence over certain sections of market. But over the long term, respected traders and those who have a keen interest in making money from markets on a consistent basis always find their own way using tried and trusted technical analysis and fundamental analysis which has been proven to work over many, many years.