What are primary factors that impact the market direction

To understand moving direction of the stock market is very crucial to your investment

Since ETFs can track stock market bull and bear directions, you need to judge which direction the market moves in.  Then make trading decisions to buy either Bull ETFs or Bear ETFs.  If your judgment is poles apart from being realistic, the harder you try, the more money you might lose.  Thus, to understand whether the market is in an uptrend, downtrend, or within trending range, is very crucial to your trading. 

There are five key factors to watch that broadly control the up-and-down movement of stock markets.

Source from Yahoo Financial, edited by blogger.

1

             Corporate earnings

Source from investopeida.com.

          Generally speaking, the stock price is determined by market value per share (often referred to as the P/E ratio) and earnings per share (often referred to as the EPS), especially in an efficient market.  Given the same level of P/E ratio, the higher the EPS is, the higher the stock price will appreciate.  A soaring P/E means that the stock has higher estimates of earnings expected in the next four quarters. 

Different industries have different levels of P/E ratio.  For example, tech companies tend to have higher P/E ratios, since investors have higher growth expectations from that industry.  In the past few years, since the recovery of the financial crisis, the rising P/E ratio has been one of the preeminent factors that have driven the US stock market rally.  However, an extended rising of the stock market might not be sustainable if the earnings do not match the same pace. This is because the shares of stock become pricy and won’t appeal to investors any more.

In bull markets, the P/E ratio tends to be higher than that in bear markets.  The P/E ratio ranges from 20-25 in bull markets historically. 

Federal Reserve Influence

Source from usatoday.com

          The direction that the Federal Reserve moves affects interest rates. 

If interest rates are hiked, the cost for corporations to function will go higher too.  It will eventually erode corporate profit, and further decrease profit margins.  The EPS will drop accordingly, which will have an inverse effect on the stock market, assuming the P/E ratio or valuation stays at a similar level.

          In recent years, especially after the financial crisis of 2007-08, the fiscal and monetary policy from major countries had a broad and deep effect on the financial marketplace. By adjusting interest rates, the central banks could adequately slow, or speed up growth, within that country. This is how monetary policy plays a role in our economy.

          On the other hand, the fiscal policy is another tool for governments to make an impact on the financial market.  By implementing a fiscal policy, our government either expands or cuts back spending. The current fiscal policy aims at abating unemployment rates and appreciating asset prices.

Technically, governments are able to alter investment inflows and outflows among countries by easing or hiking interest rates. This also influences the amount of money available on the open market. The money flow in a country has a positive effect on the strength of a country's economy, wealth, and currency. Generally speaking, if a large amount of money is leaving a country, this country's economy and currency is weakened.

On the other hand, countries that predominantly export either goods or service, reap the profits from exports flooding into the country’s revenue base. Therefore, this money can be utilized for reinvestment and stimulating the financial markets and economic bodies.

Here is an example of how capital flows can transit between countries. Due to the relative financial strength of the US economy, the United States attracts capital from other regions in the world.  Please read the article, “Capital Flows Back to U.S. as Markets Slump Across Asia” for a reference. 

Here is the link: http://mobile.bloomberg.com/news/2013-08-19/clouds-gather-over-asian-economies-as-capital-flows-back-to-u-s-.html?cmpid=

On the other hand, relative strengths or weaknesses of currency

might have a big impact on the stock market too. Traders can follow this link to find more details about how carry-trade correlates with the stock market:

http://www.marketwatch.com/story/carry-trade-unwind-could-spell-trouble-for-stocks-2013-08-23

             The World Situation

                Source from combusem.com

Economic globalization is the growing economic interconnection of economic activities among countries by the accelerated increase in exchanges of goods, services, capital, information, etc.  In the meanwhile, it creates an adjoining interdependency, and intensifies competitiveness among regions and countries. Of course, it ultimately results in much higher productivity and more optimized resource allocation.

          On the other hand, if something disastrous, such as a large scale earthquake, terrorism, or tsunami happened in any corner in the world, it might impact the entire equity markets conversely. 

                Investor Sentiment and Confidence

                 Source from rejournals.com

          When the overall investor sentiment and confidence becomes euphoric, you must be cautious because when everybody chases the market and stocks, there is not much liquidity left to boost share prices and the market level.

          On July 3, 2009, in a CNBC interview, Warren Buffet once said, “In investing, pessimism is your friend, euphoria is the enemy”.

History has shown that when the herd moves in one direction, it may be time to consider going the other way. Therefore, the sentiment detection in the stock market becomes increasingly crucial in our financial life. We are going to discuss some technical indicators which might be helpful to investors and traders.

It is worthy to mention the correlation between margin debt and market movement.  High margin debts show the consequences of over-leveraging and willingness to be more risk-taking.  Usually rising markets attract more investors to put debt to work. Most investors think it is easier to make money. 

Margins can be a double-edged sword.  When the market goes up, the brokerage houses are inclined to loan investors money. Thus, investors can increase their buying power and magnify their investment profit. 

Usually the loan from the brokerage house is collateralized by stock holdings (value in the portfolio). When the market unwinds, the share value shrinks. In the meantime, the brokerage houses become more conservative and eager to get the loaned money back.

Often the movement in a market downtrend compels brokerage firms to disallow or reduce clients’ borrowing limit, or curtail the trading on certain risky securities.  They usually establish stricter criteria. For example, they increase margin requirements. Then borrowers are either required to inject more liquidity to keep up with the margin requirement or coerced to liquidate in order to pay back the debt.

This measurement would force borrowers to sell shares in a downward market.  If many investors are executing a margin sell in about the same time frame, it will cause a market crash or collapse.  If borrowers are not willing to dump their shares, the brokerage houses will do it for them relentlessly, which might intensify the market selloff and drop share prices more violently. 

 Therefore, the margin debt would stimulate the market or accelerate the sell-off. 

On the other hand, since borrowers need to pay margin interest on their debts, their psychological perspective could change! They can’t afford to lose money! Thus, it will have a negative impact on their trading behavior too, since they’re nervous and uneasy.  This factor will disturb the market further. 

The year 1999 was a glory year for the stock market. Everybody was jubilant about his hefty profit, and both brokerage houses and investors were very bullish. Some brokerage houses even loosened the margin requirement from normal 1:1 to 4:1. For instance, if investors had $1 cash, the brokerage houses loaned them $4. 

During the tax season April 2000, many investors needed to pay large amounts of taxes for capital gain. Right before the tax date, the stock market unexpectedly dived. Investors were eager to sell because they owed large sums of tax dollars. In the meantime, the brokerages reversed the loosened margin requirement (1:4) to normal (1:1). It was an infamous “tax selling down-turn” on Wall Street.  The margin sell intensified the selling force in the stock market and caused more fear! This, in turn, caused more selling. The malicious cycle was working effectively.  When it rains, it pours.

Supply of liquidity

Supply of liquidity, QE, is another key factor that impacts the movement of the current stock market.

Quantitative easing (QE) has played increasingly more important roles in the financial marketplace and economic systems. It was first introduced by Japan. Nowadays, it has been used by central banks to inject liquidity into the economy and stimulate the economy. The Federal Reserve Bank first launched QE 1 in November 2008, and ended it in March 2010.  Then QE2 lasted from November 2010, to June 2011. 

QE3 was announced on September 13, 2012 to purchase $40 billion worth of mortgage-backed securities per month. On September 21, 2011, the Federal Open Market Committee (FOMC) announced the implementation of Operation Twist. Lastly, on December 12, 2012 the QE4 was declared to increase the bond purchasing amount from $40 billion to $85 billion. The Fed pledged to maintain the QE program until the labor market was improved significantly (6.5% unemployment rate as a benchmark). Thus, it is called QE Infinity.  The market had the best performance of the last 65 years since the QE was implemented in late 2008.

The following table outlines a summary for S&P movement during the QE1 through QE4.

Performance of the S&P for QE1 through QE4.

S&P data comes from Yahoo Finance historical prices

Note: The data for QE3, and QE4 is based on the data from 9/13/2012 to 8/1/2013.

         

          Since the current Fed chairman Mr. Bernanke is going to step

down in the end of January, 2014, his successor Mrs. Yellen is gaining attention.  We are going to wait and see how the new Fed chairman’s money policy will impact the financial market and economy.

Supply and demand for products, coupled with currencies and other investments, create a push-pull dynamic in prices. Prices and rates change as supply or demand changes. If supply increases beyond current demand, prices will subsequently fall. If supply is relatively stable, prices will fluctuate higher and lower as demand increases or decreases.

This supply and demand rule is applicable to the stock market too.  When the QE ends, it means the demand for securities decreases too. The price of equities is expected to drop assuming the P/E ratio remains at similar levels.

Since May 2013, you can count how many trading days were dominated by the Fed officers’ voices regarding the QE tapering. Since the Fed officers expressed their own opinion, and delivered the mixed information to the market, the market fluctuated along their either hawkish or dovish tones constantly!  Especially on 8/6/2013, when two Fed officers expressed the possibility the stimulus would start from as early as September 2013, the global market was definitely shaken.