How the markets work - A fundamental perspective

Hello Traders!

I'm starting this thread to share my understanding of fundamental analysis and how the markets work. Though the drivers impacting individual markets can differ, the principles I outline below are universal.

1. Changes in expectations about the future is the primary driver of the markets.
2. The price of every asset reflects a range of possible future outcomes.
3. Markets move based on new information that changes the market's perception about the probability of future outcomes.

Let me demonstrate with a very simple example. Currently there's a big debate about whether the Fed will cut 25bps or 50bps in July. Two days ago, traders priced it like this (courtesy of bulltrap):

Then, new information came into the market: Bullard said he believes a 50bps cut would be too aggressive. The new information caused traders to revise their forecasts and reposition. After Bullard, the market priced the July FOMC meeting like this:



One of these outcomes will happen (for simplicity, let's ignore other possibilities like no cut or 75bps). Depending on what the Fed does, traders who bet on a 50bps cut will make money or traders who bet on a 25bps cut will make money. Money is made in the markets by having a more accurate forecast of future events than other market participants.

Now, let's pretend you've done your research and believe there's going to be a 50bps cut. How do you trade it? Technically, the most direct bet would be to go long eurodollars or another STIR product, but I'm guessing not many people trade those instruments here. All else being equal, gold should go up with lower interest rates so going long gold would be sensible if you think the Fed will cut 50bps. This example is just one, there's almost an unlimited set of probabilities baked into the market.

I think most people understand that expectations drive market prices, but my perspective shifted some after reading Howard Mark's Mastering the Market Cycle. He contends that at any given moment an asset's price refects probabilities the market assigns on all possible future outcomes. Market expectations for next month's FOMC meeting are just one of many things influencing the price of gold. In addition to the Fed, other possible future outcomes impacting the value of gold could include:



Once new information comes out, the odds will update, positions will shift, and asset prices will change. You don't have to be right every time, you just need to be slightly more accurate than the market and you'll prosper.

A lot of good info in here! You logic is really clear and I think this thread has good potential.

If I can be so bold to add a tad of my personal opinion into the mix here:

I believe that the nature of the markets often follow physical nature as prescribed by Isaac Newton. If a bear or bull market forms due to certain economic conditions prices often continue moving in a particular direction without any more information to provide fuel. So a market with direction prefers to stay moving in its direction for a certain amount of time all else equal.

This is not to say that markets don’t get stuck range bound or experience corrections but that momentum and trends over various timeframes should be taken into account.

You said it. And therein lies the problems associated with trading decisions based on fundamentals. False & misleading news articles prompt market moves just as legitimate news does.
Traders must learn chart patterns & in particular candle behavior. Learning how a candle is liable to react to the behavior of the previous candle or candles is very important.

Yes, what you're getting into is the fundamental reason trends exist. I agree that Newton's first law of motion is applicable, however it's a bit more complicated than that. I'll try to explain it in detail when I get some time.

I don't think inaccurate news is necessarily a problem. All news can't be taken at face value so if you see something you don't think is right, just fade the move and profit. Here's a great example of one such case: https://www.marketwatch.com/story/th...nic-2018-04-23

I would be careful about any too "set in stone" conclusions/derivations, because market rules do change.
Sometimes nothing work... And also, at central banks at play... it can out-noise any model/prediction etc...
unless you have the one that predicts moves of the titans (ECB/FED etc..) that is..

And about the 25-50 rates.. It appears that the market moved (only) based on that... but there is much going on... because everything is relative here...
If the ECB follows the FED it might neutralise... If the stability increases or decreases in the world...

In fact... sometimes markets "price-in" the error also... If we watch the high economic news.. and see some number... and the actual might be much higher (assuming positive correlation)... prices might DROP, because some (big) players or (many) traders predicted the even higher market and since it didn't reach.. they went the other way...

You're absolutely right. I think changes in expectations driving the market is universal, but individual relationships change all the time. Take stocks and bonds for instance, usually stocks are attractive due to growth and bonds are more for safety. How can it be that both are at multi-year highs right now? Well, ordinary they wouldn't be but the Fed has gotten way more dovish which provides a tail-wind for both asset classes. Not a lot of models can handle in something like that, and to even try I think you'd have to incorporate something unusual like the futures curve for ZQ.

You know how sometimes problems occur in the economy and the markets panic, then sort of just stop caring? It's an interesting phenomena that I've seen numerous times. I was rereading an article over the weekend that touched on this phenomena and I thought I'd share:

My view is that as time passes, the market will continue to acclimatize to the two issues that it’s been most worried about over the last year: (1) economic weakness and potential instability in China and (2) the credit implications of the energy downturn. A similar acclimatization happened with the Euro crisis. It always seems to happen with these types of issues. The process works like this. New “problems” emerge, catching investors off-guard. Many investors come to believe that this is it, the start of the “big” move lower. The market undergoes a series of gyrations as it wrestles with the problems. Eventually, market participants get used to them, accustomed to their presence, like a swimmer might get accustomed to cold water. The sensitivity, fear and reactivity gradually dissipate. Unless the problems continue to deteriorate, investors gravitate back into the market, even as the problems are left “unsolved.”