By Daniel Archibald | CFA
Theoretical physics describes and models the forces that are known to shape our world. Non-physicists would be well aware of 2 of these fundamental forces; gravity and electromagnetism. The former is what keeps our feet firmly planted on the earth and pulls objects together across vast distances of space. The latter is what helps electricity to flow and charged particles to repel or attract.
Professional and amateur physicists would also be familiar with the other 2 fundamental forces; the strong and the weak nuclear forces. In this case, the former is the attractive force that keeps atoms intact and the latter helps particles to change and decay. The nuclear forces play a much bigger role at the atomic and sub-atomic (quantum) level, while gravity only really affects larger particles and masses. The electromagnetic force plays somewhat in between the quantum world and everyday world.
As the name would suggest, the strongest of all these forces is the strong nuclear force (i.e. the energy needed to keep protons connected with neutrons is relatively powerful). Surprisingly, the force that has the least influence is gravity. This is evident when comparing the ease at which a small magnet can counter the gravitational force from the mass of the earth in lifting a small coin or paperclip.
While not looking to take the following analogy too far, there are similar 'fundamental forces' that affect our capital markets (e.g. bond market, share market, etc). And like the fundamental forces of nature, some of these may have a much lower influence on market mechanics than what is commonly thought. The 4 market forces that might fit this analogy well are:
- Economic activity
- Money supply
- Market infrastructure
- Trust
Starting with the first of these forces, economic activity would seem to be an obvious factor in determining how markets will move. If the economy is doing well, companies will be earning profits and share prices will go up. The opposite would also seem to be accurate. However, numerous studies have shown the lack of correlation between economic activity (as measured by GDP growth) and share price growth. Long-term, this would seem to be a powerful influence on markets, however (perhaps like gravity), in the short-term, economic activity has much less sway over the market then what might be expected.
The next of these forces is the supply of money. Money is the oil of the economic system, and a steady supply of money helps the global engine of commerce and trade to power on. The store, production and momentum of money can have a strong influence on asset prices with surplus cash generally pushing up the prices of relatively scarce investments. Surpluses are generally driven by central bank policies (i.e. low interest rates and money printing), but can also be a result of foreign investment preferences (e.g. flows of capital to and from different countries or regions). In the short-term, money supply can easily overcome the pull of economic conditions.
Market infrastructure forces refers to the technological and legislative systems that can influence asset prices. The advent of computers has dramatically increased the speed and security by which financial transactions can be accomplished. Also, deregulation of markets, as well as increased protections for asset owners, have helped to reduce the cost of trading. Overall, progressive market infrastructures help to increase the volume of market trade, improve price discovery and encourage investment - leading to lower risks and higher prices.
The last of these forces, though it may seem to be insignificant compared to the others, is probably the strongest of all. Trust in the market, whether it be in the form of investor sentiment or counterparty risk, is really the basis for the financial system. Without trust, fiat currencies are worthless and stock prices head towards zero. When trust is eroded, there is no commerce and there is no trade. Almost every significant market collapse has been a crisis in confidence, with the last big crash in 2008/09 being no different. In the long-run and invisible as it may seem, trust holds the elements of the market together. In the short-run, when trust in the market is broken this unseen force can have an extremely powerful impact.