If you hang around BigFoot Investments long enough, one of the things you’ll hear is that markets have breathing patterns: in, out; up, down; over-bought, over-sold.
It’s tough to judge when markets are over-bought or over-sold. What does that even mean?
It’s less complicated than you think. Markets are an auction. With auctions, sometimes the excitement of the moment can lead prices to get out of whack. Investors (or more accurately, traders) will develop a short-term rationale for why the market should do one thing or another.
In a sense, the short-term rationales can become self-fulfilling prophesies. If enough buyers or sellers get on board, the markets can move. After all, underneath all the analysis and hoopla, the formula for the price of a stock is quite simple. It’s the intersection of supply and demand.
So when you think about the market’s breathing patterns, part of the thought process should include looking at supply and demand. Of course, there’s some circular logic at work here, because price affects supply and demand while supply and demand simultaneously affect price.
The analysis can get pretty deep, but ultimately, the price of the stock is determined by supply and demand. The rest of the analysis is trying to rationalize or predict the variables that will influence this equation in an attempt to divine future outcomes. (Even the subject of this blog, when distilled down, is often just a prediction based on data. And, as last week will show, those predictions are not always correct.)
So analysis, at least when it comes to price discovery, tends to be an educated guess. What will influence price to go higher or lower?
Since price itself is part of the influence of future pricing, one can expect that price to change if there is any liquidity demand in the future (because let’s face it, if no one wanted to buy or sell something, that’s not really a market anymore).
As prices move higher, demand should decline. At some point, prices get too high and supply exceeds demand at that price, so price declines. So price movement also influences demand. And viola, a trend is born.
But what does this have to do with a breathing pattern?
Quite simply, sometimes the news hasn’t changed much. So the rationale for why someone would or would not own an investment hasn’t really changed. But prices have changed because of the basic shuffle in the marketplace and the dynamic of trends. Prices go higher, so some buyers want to buy before the price goes even higher; others want to sell while the price is going up. It is the imbalance of buyers or sellers that moves the price.
At some point, absent significant changes in the news cycle, the balance of buyers versus sellers can shift. Really anything could cause this shift – but whatever it is, the balance shifts and the trend changes. Prices go from climbing to falling (or perhaps the other way around).
How high or low a market goes will vary. But often times a long-term trend is associated with short-term trends. The short-term trends are the ‘breathing patterns.’
Okay. We get it. Why all the long-winded explanation about trends and how prices go higher or lower??? Who cares.
Well, investors care, when they’re trying to predict the future. The larger point here is that analysis can come in all kinds of flavors, but it’s still just an educated guess as to what the markets are going to do in the future. The trick is, we believe it. And when enough people get on board with an idea, the behavior starts to manifest. (We can talk about all kinds of ways this is true, but that’s a subject for another time or another blog).
Today, looking at the trends and charts and all the stuff that rationalizes an opinion, the markets look over-bought. See exhibit A below:
Notice in Exhibit A how last week’s price was above both the shaded area and the bold white line? This is an indication that there were more buyers than sellers last week, and that prices are above ‘average’ by a number of measurements.
When prices get above average, it’s common to see prices move lower in the short-term. We call it mean reversion. And, for most of you regular readers, you already know this term. But it’s worth repeating now and then.
The question to ask is ‘why are markets moving higher?’ Does this make sense given the data?
As the economy re-opens and the government continues to conjure money to throw into the system, it explains the move higher.
This is not to suggest there can’t or won’t be a price correction. It is merely a reflection of the fact more money is in circulation, and those dollars buy stuff. If the stock market is the most attractive place for new dollars to go live, that’s where they go. And the increased demand can drive prices higher.
So three trends seem to be emerging:
Really short-term (as in,the next few days), the markets looks over-bought and due for a mild pull-back… maybe 1 or 2 percent.
Intermediate-term (as in, the next quarter or so), the markets seem to generally have the wind at their back as Covid appears to be subsiding and the economy re-opens.
Intermediate-to-longer term (as in the next 6-to-12 months), probably looks pretty good.
Longer-term (as in more than a year out)… punt. There are too many wild cards, most of which come with massive government bond buying and money printing (which eventually has a consequence even if it doesn’t seem to yet).
So where does that leave us? Well, see exhibit B below:
It appears the S&P 500 may be weak to start the week out, but has a limited downside with support near 4067. Assuming it finds its footing early, a sideways to positive trend is likely to emerge, with yet another all-time high likely to get pegged this week.
Until some kind of news changes sentiment it looks like the markets can move higher from here. But, as always, we reserve the right to be wrong.
Have a great week!
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