Price Prediction
Traders don’t take positions in the futures market without an informed opinion about where
the market appears to be headed. They won’t go long without some kind of signal that
prices are moving up, and they won’t go short without a signal that prices are headed down.
They don’t operate blindly, and they don’t throw darts at a dart board or hold séances to
form an opinion about price movement (at least we hope not). What are these signals?
Where do they come from, and how do traders use them to form educated opinions?
The signals come from two very different kinds of research — the analysis of external events
that affect the markets (fundamental analysis) and the analysis of historical patterns of
price movements (technical analysis). Each approach has its followers among hedgers and
speculators. While some people are purists who advocate one type of analysis over the other,
many others engage in both.

Fundamental Analysis
Fundamental analysis focuses on cause and effect — causes external to the trading markets
that are likely to affect prices in the market. These factors may include the weather, current
inventory levels, government policies, economic indicators, trade balances and even how
traders are likely to react to certain events. Of course, fundamentalists have to know what to
look at (the factors differ for each commodity) and how to interpret the information available.
Suppose, for example, that you take a fundamentalist approach to buying a house in a
certain area. You would start by looking at factors affecting prices in that area. You might
discover there’s been too much new construction this season, and that there are also many
older homes on the market because of cutbacks at a local corporation. You’d note that sales
are sluggish compared to earlier years and that currently there are more houses available
than buyers — supply is greater than demand. Your fundamental research tells you that
homes in that area will be priced at value or possibly even under-priced, so you’re likely to
get a good deal if you act before the situation changes.

Supply and Demand
Because fundamentalists hope to predict which way prices will move, they’re interested
in identifying factors that are likely to affect supply and demand. When the supply of a
commodity increases and demand decreases or stays the same, the price falls (just like those
tomatoes we talked about earlier). When supply decreases and demand increases or stays
the same, the price of that commodity rises. If the supply stays the same, changes in
demand will cause prices to rise or fall.

The fundamentalist studies how events change the value of the commodity — whether it
becomes more valuable or less as a result of an event — and whether prices can be expected
to go up or down because of the event. Because all public information about a commodity
ultimately will be reflected in its price, fundamentalists try to determine how and when these
factors will affect the market price, so they can trade accordingly. Fundamentalists also study the psychological effects of various kinds of information on traders. In other words, how and when do traders respond to a certain type of event or release of information? The fundamentalist analyzes this response and hopes to trade before the information is incorporated into the price. This lag time between an event and its resulting market response presents a trading opportunity.

Agricultural Fundamentals
Because each market has different supply and demand factors, fundamentalists typically
only trade in markets they know. What needs to be known about the cattle market is quite
different from what needs to be known about the currency market. Fundamentalists trading a crop will watch last year’s carryover stock and this year’s projected production, usage and ending stock to predict the direction of price movement. The U.S. Department of Agriculture (USDA) releases this information in Crop Production Reports each month and includes price projections of its own. A fundamentalist takes nothing for granted and will fine-tune these projections with further analysis. Fundamentalists will compare this year’s statistics with those of previous years and try to identify how prices have moved in similar situations. They also will analyze external factors affecting the current supply and demand for the crop. On the supply side for corn, for example, fundamentalists study factors affecting acreage and yield numbers. Low corn prices can encourage producers to plant other crops or participate in government production control programs, while high prices are an incentive to plant more. Weather during the growing season affects the number of bushels per acre produced. On the demand side for corn, livestock numbers indicate a rising or falling demand for feed. Fundamentalists also take into account those international factors that can increase or decrease the demand for corn exports. Even the U.S. dollar exchange rate can affect how competitive U.S. corn is in the world market. Fundamentalists pay close attention as all of these events unfold.

Livestock Fundamentals
Livestock fundamentals are very different from crop fundamentals. There are no carryover
stocks, because livestock are non-storable. Therefore, the current supply is the key livestock
fundamental to watch. Let’s take a look at cattle, for example. Basically, producers determine what the cattle supply will be based on the answer to one question: How profitable is it to raise cattle? The market price of cattle and the cost of feed affect this profitability. High profitability
encourages producers to enlarge breeding programs, increasing supply and eventually
causing prices to fall. Low profitability works the opposite way. Producers will cut back on
breeding programs, decreasing the supply and eventually causing prices to rise. Because
herd building and herd reduction take time, this is a longer cycle than the cycle for crops.

Current supply numbers are available in the monthly USDA Cattle on Feed Report.
Fundamentalists develop formulas to determine what effect an increase or decrease in
supply over last year will have on prices. They also look closely at the potential effect
of government programs on cattle supply. A milk reduction program, for example, could
lead to increased supply because dairy farmers may have to slaughter their herds to
comply with the program. Hog producers control hog supply and react to profitability in the same way that cattle producers do. The quarterly USDA Hogs and Pigs Report (a sample follows) provides a primary source of statistics which fundamentalists can study to project supplies and
formulate realistic hog prices. Fundamentalists may develop econometric models to determine livestock demand factors. Inflation, consumer tastes, consumption patterns and population numbers all affect the demand for meats. Meat products are competitive, meaning that consumers will substitute one meat for another, depending on prices. For example, when beef prices are low, people tend to consume less pork, while high beef prices will increase the demand for pork.
A commodity that is highly demand-driven is lumber. Lumber fundamentalists use the
monthly Housing Starts Report from the U.S. Department of Commerce as a key indicator
of demand, as well as other information on general economic conditions affecting the
building industry such as employment levels, mortgage interest rates and inflation.

Financial Fundamentals
Fundamentalists in the financial futures markets — whether in foreign currencies, interest
rate products, or index products — work with a complex array of supply and demand factors
to predict price movement. The foundation for financial fundamental analysis is the study of
the overall health of the economy that affects each of these markets.

Financial fundamentalists watch a number of economic indicators to determine changes
in the state of the economy. Some examples are listed here, but there are many others.
The supply and demand for money determines interest rates, and changes in the economy’s
direction normally precede major interest rate turning points. Financial fundamentalists
study economic indicators and prevailing economic policies to determine the direction of the
economy. They use these indicators to forecast interest rates and, subsequently, the prices
of interest rate products such as U.S. Treasury Bills. In general, the demand for money rises
during economic expansion, causing interest rates to rise. Likewise, the demand for money
falls during economic recession, causing interest rates to fall. Analysis of long-term versus
short-term interest rates can also signal the direction of interest rate movement.
Fundamentalists trading in the currency markets study the U.S. economy as well as that of
other countries. The price of one currency in relation to another shifts as supply and demand
factors shift. For example, fundamentalists trading CME British pound futures consider the
strength of the British economy, its fiscal and economic policies, budget deficits, balance of
trade levels, inflation trends and general political situation — factors that are reflected in the
value of the British pound.

Market psychology plays an important role in the financial markets, and it pays for the
fundamentalist to be familiar with the market’s response to economic indicators and news.
Rumor, expectations and human behavior have a tremendous impact on price movement.
The fundamentalist needs to be smart enough to tell when the market is oversold or
overbought due to the excitability of the traders.

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