4 Factors That Shape Market Trends

Trends are what allow traders and investors to capture profits. Whether on a short- or long-term time frame, in an overall trending market or a ranging environment, the flow from one price to another is what creates profits and losses. There are four major factors that cause both long-term trends and short-term fluctuations. These factors are governments, international transactions, speculation and expectation, and supply and demand.

Major Market Forces

Learning how these major factors shape trends over the long term can provide insight into why certain trends are developing, why a trend is in place and how future trends may occur. Here are the four major factors:

1. Governments
   Governments hold much sway over the free markets. Fiscal and monetary policy has a profound effect on the financial marketplace. By increasing and decreasing interest rates the government and Federal Reserve can effectively slow or attempt to speed up growth within the country. This is called monetary policy.
   
   If government spending increases or contracts, this is known as fiscal policy, and can be used to help ease unemployment and/or stabilize prices. By altering interest rates and the amount of dollars available on the open market, governments can change how much investment flows into and out of the country.
2. International Transactions
   The flow of funds between countries impacts the strength of a country's economy and its currency. The more money that is leaving a country, the weaker the country's economy and currency. Countries that predominantly export, whether physical goods or services, are continually bringing money into their countries. This money can then be reinvested and can stimulate the financial markets within those countries.
3. Speculation and Expectation
   Speculation and expectation are integral parts of the financial system. Where consumers, investors and politicians believe the economy will go in the future impacts how we act today. Expectation of future action is dependent on current acts and shapes both current and future trends. Sentiment indicators are commonly used to gauge how certain groups are feeling about the current economy. Analysis of these indicators as well as other forms of fundamental and technical analysis can create a bias or expectation of future price rates and trend direction.
4. Supply and Demand
   Supply and demand for products, currencies and other investments creates a push-pull dynamic in prices. Prices and rates change as supply or demand changes. If something is in demand and supply begins to shrink, prices will rise. If supply increases beyond current demand, prices will fall. If supply is relatively stable, prices can fluctuate higher and lower as demand increases or decreases.

Effect on Short- and Long-Term Trends

With these factors causing both short- and long-term fluctuations in the market, it is important to understand how all these elements come together to create trends. While these major factors are categorically different, they are closely linked to one another. Government mandates impact international transactions, which play a role in speculation, and supply and demand plays a role in each of these other factors.

Government news releases, such as proposed changes in spending or tax policy, as well as Federal Reserve decisions to change or maintain interest rates can have a dramatic effect on long term trends. Lower interest rates and taxes encourage spending and economic growth. This has a tendency to push market prices higher, but the market does not always respond in this way because other factors are also at play. Higher interest rates and taxes, for example, deter spending and result in contraction or a long-term fall in market prices.

In the short term, these news releases can cause large price swings as traders and investors buy and sell in response to the information. Increased action around these announcements can create short-term trends, while longer term trends develop as investors fully grasp and absorb what the impact of the information means for the markets.

The International Effect

 International transactions, balance of payments between countries and economic strength are harder to gauge on a daily basis, but they play a major role in longer-term trends in many markets. The currency markets are a gauge of how well one country's currency and economy is doing relative to others. A high demand for a currency means that currency will rise relative to other currencies.

The value of a country's currency also plays a role in how other markets will do within that country. If a country's currency is weak, this will deter investment into that country, as potential profits will be eroded by the weak currency.

The Participant Effect

The analysis and resultant positions taken by traders and investors based on the information they receive about government policy and international transactions create speculation as to where prices will move. When enough people agree on direction, the market enters into a trend that could sustain itself for many years.

Trends are also perpetuated by market participants who were wrong in their analysis; being forced to exit their losing trades pushes prices further in the current direction. As more investors climb aboard to profit from a trend, the market becomes saturated and the trend reverses, at least temporarily.

The S & D Effect

This is where supply and demand enters the picture. Supply and demand affects individuals, companies and the financial markets as a whole. In some markets, such as the commodity markets, supply is determined by a physical product. Supply and demand for oil is constantly changing, adjusting the price a market participant is willing to pay for oil today and in the future.

As supply dwindles or demand increases, a long-term rise in oil prices can occur as market participants outbid one another to attain a seemingly finite supply of the commodity. Suppliers want a higher price for what they have, and a higher demand pushes the price that buyers are willing to pay higher.

All markets have a similar dynamic. Stocks fluctuate on a short and long-term scale, creating trends. The threat of supply drying up at current prices forces buyers to buy at higher and higher prices, creating large price increases. If a large group of sellers were to enter the market, this would increase the supply of stock available and would likely push prices lower. This occurs on all time frames.

The Bottom Line

Trends are generally created by four major factors: governments, international transactions, speculation/expectation, and supply and demand. These areas are all linked as expected future conditions shape current decisions and those current decisions shape current trends. Government affects trends mainly through monetary and fiscal policy. These policies affect international transactions which in turn affect economic strength. Speculation and expectation drive prices based on what future prices might be. Finally, changes in supply and demand create trends as market participants fight for the best price.

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The British Pound: What Every Forex Trader Needs To Know

Introduction to the British Pound

The British pound (also called the pound sterling) is one of the most economically and financially important currencies in the world. The pound is the fourth-most traded currency in terms of turnover and it is the third-most widely held reserve currencies among the countries of the world.

The pound holds a significant place in economic history, as it was once the world's dominant currency and held the position now owned by the U.S. dollar in terms of its significance in international trade and accounting. Given the economic consequences of World War II and the breakup of the U.K.'s global empire, the pound lost its preeminence in the 1940s but has certainly not slipped beyond relevance.

The pound also holds an interesting place in the history of hedge funds and currency speculation. Britain joined the European Exchange Rate Mechanism in 1990, a "semi-pegged" exchange rate system in Europe that was meant to ease some of the volatility in exchange rates and prepare the way for a single currency. Unfortunately, the system did not provide the advertised benefits and Britain experienced both recessionary pressures and high outflows from the Bank of England in a vain effort to maintain the stated rate.

Currency speculators, led most famously by George Soros, bet that this rate could not hold (as economic conditions made it unsustainable) and aggressively shorted the pound. Ultimately, Britain withdrew from the system (on Wednesday, September 16, 1992 known as "Black Wednesday") and Soros alone profited in excess of $1 billion from his moves.

All of the major currencies in the forex market have central banks behind them, and the pound is managed by the Bank of England. While almost every Western central bank views inflation control has a preeminent mandate (along with promoting some level of economic growth), the Bank of England has explicitly followed a policy of targeting 2% inflation. 


The Economy Behind the British Pound

Looking at nominal GDP, as of 2011 the United Kingdom is the sixth-largest economy in the world. The U.K. has enjoyed consistent (albeit not spectacular) growth for most of the past two decades, with the global credit crisis and recession taking its toll in 2008. Inflation has been an intermittent issue; inflation ran as high as 8% in the early 1990s, but traded at more reasonable levels withing the last couple of years.

More potentially worrisome has been the recent increase in debt as a percentage of GDP. After peaking near 50% of GDP in the late 90s, Britain's balance sheet improved consistently. Since 2008, though, debt has increased sharply.

While Britain does belong to the European Union, it is not a member of the Eurozone, meaning that it retains complete sovereignty over its fiscal and monetary policy. Even by the standards of Europe, though, the U.K. has a highly globalized economy and London is regarded as the world's second-most important financial center. Perhaps not surprisingly, then, Britain is seen as a viable alternative for companies wishing to raise capital without the expenses and hassles of complying with U.S. securities regulations.

Britain has generally pursued pro-business policies and is a major global competitor in advanced industries like pharmaceuticals and aerospace, as well as services like banking, finance, advertising and accounting. Britain is an aging country, but has a globally competitive workforce.

While the United States is Britain's largest single trading partner, Europe as a whole is a major source of both imports and export demand. Consequently, economic conditions and policies in Europe have a major impact on the economic health of the U.K. and traders who wish to trade the pound would do well to follow the eurozone economic data almost as closely as the data from the U.K. itself.

Drivers of the British Pound

Economic models designed to calculate the "right" foreign currency exchange rates are notoriously inaccurate when compared to real market rates, due in part to the fact that economic models are typically based on a very small number of economic variables (sometimes just a single variable like interest rates). Traders, however, incorporate a much larger range of economic data into their trading decisions and their speculative outlooks can themselves move rates just as investor optimism or pessimism can move a stock above or below the value its fundamentals suggest.

Major economic data includes the release of GDP, retail sales, industrial production, inflation and trade balances. These come out at regular intervals and many brokers, as well as many financial information sources like the Wall Street Journal and Bloomberg, make this information freely available. Investors should also take note of information on employment, interest rates (including scheduled meetings of the central bank), and the daily news flow – natural disasters, elections, and new government policies can all have significant impacts on exchange rates.

With its stated policy of maintaining inflation around 2%, the interest rate announcements (and commentary) from the Bank of England are tremendously significant to how the pound trades. Along similar lines, traders frequently monitor major commodities like oil, natural gas, and grains as bellweathers for possible inflationary pressures.

Britain is also a major destination for global investing, and those flows can certainly influence exchange rates. Britain has increasingly become a favored alternative destination to New York for raising capital and that activity influences the currency. The carry trade is not a tremendously significant factor for the British pound.

Unique Factors for the British Pound

As the third-most widely held reserve currency, the British pound holds a place of significance that seems somewhat outsized to its economic role in the world. Part of this is no doubt due to the country's status as a financial trading center and financial capital for Europe, but some of it is also due to the country's long history of global leadership.

The U.K. also enjoys a somewhat volatile reputation as a relative prudent and conservatively-run economy. While this perception certainly ebbs and flows on the basis of which party rules the country (and the extent to which those policies favor or curtail public spending and transfer payments), there is nevertheless a widely held view that the U.K. will typically target prudent and conservative policies aimed at consistent (albeit not exciting) growth. It is also worth noting that the pound is one of the relatively few currencies that is worth more than the U.S. dollar (meaning that one pound buys more than one dollar).

The Bottom Line

Currency rates are notoriously difficult to predict, and most models seldom work for more than brief periods of time. While economics-based models are seldom useful to short-term traders, economic conditions do shape long-term trends.

Britain may be small in terms of its population and land mass, but it is a major global economy with a very long and rich history of global economic leadership. The U.K. has seemingly found a good balance between manufacturing and services for its economy, while pursuing policies geared towards stability and predictability. As a strong alternative to the dollar it is likely that the pound will remain a preeminent global currency for some time to come.


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The 3 Biggest Risks Faced By International Investors

Investing internationally has often been the advice given to investors looking to increase the diversification and total return of their portfolio. The diversification benefits are achieved through the addition of low correlation assets of international markets that serve to reduce the overall risk of the portfolio. However, although the benefits of investing internationally are widely accepted theories, many investors are still hesitant to invest abroad. In this article, we'll discuss the reasons why this may be the case and help highlight key concerns for investors so they can make a more informed decision. 

Transaction Costs

Likely the biggest barriers to investing in international markets are the transaction costs. Although we live in a relatively globalized and connected world, transactions costs can still vary greatly depending on which foreign market you are investing in. Brokerage commissions are almost always higher in international markets compared to domestic rates. In addition, on top of the higher brokerage commissions, there are frequently additional charges that are piled on top that are specific to the local market, which can include stamp duties, levies, taxes, clearing fees and exchange fees. 

As an example, here is a general breakdown of what a single purchase of stock in Hong Kong by a U.S. investor could look like on a per trade basis:

Fee Type             Fee

Brokerage Commission HK$299

Stamp Duty        0.1%

Trading Fees      0.005%

Transaction Levy              0.003%

TOTAL   HK$299 + 0.108%

In addition, if you are investing through a fund manager or professional manager, you will also see a higher fee structure. To become knowledgeable about a foreign market to the point where the manager can generate good returns, the process involves spending significant amounts of time money on research and analysis. These costs will often include the hiring of analysts and researchers who are familiar with the market, accounting expertise for foreign financial statements, data collection, and other administrative services. For investors, these fees altogether usually end up showing up in the management expense ratio.

One way to minimize transaction costs on buying foreign stock is through the use of American Depository Receipts (ADRs). ADRs trade on local U.S. exchanges and can typically be bought with the same transaction costs as other stocks listed on U.S. exchanges. It should be noted however, that although ADRs are denominated in U.S. dollars, they are still exposed to fluctuations in exchange rates that can significantly affect its value. A depreciating foreign currency relative to the USD will cause the value of the ADR to go down, so some caution is warranted in ADRs.

Currency Risks

The next area of concern for retail investors is in the area of currency volatility. When investing directly in a foreign market (and not through ADRs), you have to exchange your domestic currency (USD for U.S. investors) into a foreign currency at the current exchange rate in order to purchase the foreign stock. If you then hold the foreign stock for a year and sell it, you will have to convert the foreign currency back into USD at the prevailing exchange rate one year later. It is the uncertainty of what the future exchange rate will be that scares many investors. Also, since a significant part of your foreign stock return will be affected by the currency return, investors investing internationally should eliminate this risk.

The solution to mitigating this currency risk, as any financial professional will likely tell you, is to simply hedge your currency exposure. However, not many retail investors know how to hedge currency risk and which products to use. There are tools such as currency futures, options, and forwards that can be used to hedge this risk, but these instruments are usually too complex for a normal investor. Alternatively, one tool to hedge currency exposure that may be more "user-friendly" for the average investor is the currency ETF. This is due to their good liquidity, accessibility and relative simplicity.

Liquidity Risks

Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. Liquidity risk is the risk of not being able to sell your stock quickly enough once a sell order is entered. In the previous discussion on currency risk we described how currency risks can be eliminated, however there is typically no way for the average investor to protect themselves from liquidity risk. Therefore, investors should pay particular attention to foreign investments that are, or can become, illiquid by the time they want to close their position.

Further, there are some common ways to evaluate the liquidity of an asset before purchase. One method is to simply observe the bid-ask spread of the asset over time. Illiquid assets will have wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity. Altogether, these basic measures can help you create a picture of an asset's liquidity.

Bottom Line

Investing in international stocks is often a great way to diversify your portfolio and get potentially higher returns. However, for the average investor, navigating the international markets can be a difficult task that can be fraught with challenges. By understanding some of the main risks and barriers faced in international markets, an investor can position themselves to minimize these risks. Lastly, investors face more than just these three risks when investing abroad, but knowing these key ones will start you off on a strong footing.

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