From last couple of weeks I am receiving multiple messages from readers and clients, enquiring about the status of Financial Markets, not just related to Stocks, even about Currencies and Commodities. (As most of my frequent readers know that I focus not only on stocks; I also look for opportunities across different segments such as Currencies and MCX Commodities.)
Most of the Questions were like – What’s happening in the Stock Market? Why did Gold Prices fell suddenly? Is it a good time to Short USD/INR? Why there’s so much volatility in the markets? Etc.
The best way to answer to these questions is to understand what’s driving the Market Prices. Once we figure out that, we can understand what’s happening in the markets and get better in the trading game. Also it’s important to know how market prices move in the long run and short run, so that a serious trader can design a best trading approach out of it.
The 2 most important elements that drive the Market Prices are – Sentiment and Liquidity
Sentiment
In the short term, the one and only thing that moves the market is Sentiment. Market Participants often perceive the markets with a combination of Rationality and Emotion. Such a perception is what we refer as Sentiment. If a set of Big Players take a negative outlook on the Market, asset prices will fall in the short run. Likewise, if a large group of market participants are overwhelmingly bullish, markets will rally. Regardless of Fundamentals, Sentiment drives the short term movements.
When the markets are volatile, Traders become emotional and their activity can push the prices to extremes. But these Sentiment extremes often self corrects and adjusts according to underlying realities within a short duration. Sentiments can change pretty quickly in the markets.
Sometimes markets can also be sentimentally manipulated. All financial markets to some degree are susceptible for manipulations. But these manipulations cannot last for a longer period.
For e.g: When market environment suddenly changes to negative, a large trader with long positions might try to accumulate more shares to stop the downside, which could create a positive sentiment on lower time frame. But the large trader can’t accumulate forever; sooner or later market prices will have to adjust itself to the environment.
Just because the sentiment can be manipulated doesn’t mean the markets are bad. Instead of judging the markets you need accept the reality and try to use it to improve your trading approach. That’s the core principle in our Price Action Trading Strategies.
Liquidity
Over the Long run, Market prices are always driven by Liquidity. Liquidity creates multiyear trends in Financial Markets. When I say Liquidity I am not referring to traditional definition, instead I mean “Economic Liquidity” – The Overall money flow that comes from Domestic and Global economy.
For e.g: When a Country’s central bank reduces the Interest rates, the lending capacity improves in the Country. Businesses will borrow to expand and the consumers will borrow to spend. In such cases, more money will flow into the hands of entities like MNC, Corporations and Financial Institutions which is then invested in Stock Markets directly or indirectly. Such kind of Money flows is termed as Economic Liquidity – it can create strong multiyear trends in Stock prices.
Many Long term investors think that once you identify and Buy a good stock based on strong Fundamentals, automatically the value of the stock increases in the long run. But the fact is no matter how fundamentally strong a stock is, without sufficient Economic liquidity, its stock prices will not improve. Far worse, when the Economic Liquidity decreases, stock prices will crash altogether. Most of the Stock market crashes happen because of that.
Economic Liquidity is influenced by wide variety of Macro economic variables such as Central Bank policies, Government policies, Economic growth, Demographics and Global disasters such as war, pandemic etc.
As a Conclusion, Market prices are driven by the combination of Liquidity and Sentiment. Liquidity drives the market prices in the long run and Sentiment drives the market prices in the short run. To have a trading edge and succeed in the markets, you must design your strategies based on these two elements. The more we understand the markets, the better we can trade it.
