What is Market Force Analysis?
Market Force Analysis (MFA) is a unique approach to commodity market analysis (patent pending). An algorithm has been developed to extract supply and demand from futures market data. The difference between supply and demand is the market imbalance which is called market force, so named because it is that which drives price. It brings clarity to past market action and predicts future market trends. Because it is derived from accurate futures market data it is not subject to the errors inherent in macro-level estimates of supply and demand.
Market Force Analysis
Market Force Analysis (MFA) has three outputs
The direction of the force indicates that the primary trend is up. Just this information already brings clarity to market analysis because many analysts argue for a long time whether a primary trend has changed or not.
Furthermore, in figure 1 it can be seen that demand is in a strong rising trend and supply is in a declining trend. This is indicative of a very powerful bull market. The force could rise when demand and supply are both rising, if demand rises faster than supply, but that will be a much weaker bull market. If the force is in a declining trend then the commodity is question is in a bear market, or in other words the primary trend is down.
Investors do not just want to know the direction of the long term primary trend; they also want to know the direction of the secondary trend and when it changes, for the purposes of making short term trades to take advantage of the ebb and flow of the market which occurs super-imposed on the primary trend.
MFA and Equilibrium Regressional Analysis (ERA)
A recent development of MFA called Equilibrium Regressional Analysis (ERA) allows short term trading entry and exit points to be accurately identified.
First of all let’s look at economic theory of how price and supply-demand imbalance (force) should be related.
Figure 2 shows the theoretical relationship between price and demand-supply imbalance. The right-hand side of the chart (shortage) is when demand greatly exceeds supply and so price rises almost vertically. The price will tend to infinity (or a very big number) as demand massively outstrips supply. If supply is greater than demand then demand minus supply is negative and we are on the left-hand side of the chart (oversupply). In this case the price is low and will tend to a zero value price at infinite supply. Joining the two extremes we get a curve which is exponential in nature.
We would expect any commodity to follow this relationship. However, this is the ‘equilibrium’ relationship of price to market force. There are transient affects that cause perturbations of the price from the equilibrium.
Figure 3 demonstrates market mechanics. A perfectly fundamentally driven market proceeds as shown by the green arrow. Price changes as the demand-supply imbalance changes and follows the exponential relationship. In other words the price is the equilibrium price as dictated by supply-demand imbalance. A bull market would mean the data follows the curve from left to right while a bear market would mean the data moves along the curve from right to left. The clustered blue dots show what happens with exuberant rallies as sentiment drives prices higher than the equilibrium, while extreme pessimism, as shown by the green dots, drives the price below the equilibrium price. A good analogy would be a beach ball floating on a river. The ball could be released at the river’s source and it would flow down stream toward the sea or it could be pushed gently upstream toward the river’s source. At any time the ball could also be pushed below water or the wind could pick it up off the water but the ball will return eventually to its equilibrium of floating on the water.
We will see that the equilibrium price is an excellent way of predicting an appropriate short term trading exit or entry point as the departure from equilibrium can only go so far before there will be an expected return to the mean equilibrium price.
Modeling Commodity Prices
Figure 4 shows a cross-plot for the gold price and market force from 2000 to 2009. The correlation is fitted with an exponential relationship as was predicted from theory. The chart looks very similar to our theoretical chart of figure 3.
It can be seen in this actual data that there are departures to the upside and the downside from this equilibrium price relationship as theory predicted. Using the equation of this exponential relationship and the historical market force data the equilibrium gold price can be calculated. The equilibrium gold price and the actual gold price are shown in Figure 5. It can be seen that over 27 years the comparison is excellent. What is clear is that when the actual price deviates from the equilibrium it will at some point regress back to it. This is the principle of Equilibrium Regressional Analysis (ERA) to analyze and predict this very fundamental mechanism that is founded in economic theory.
While the principle has been demonstrated using gold as an example other commodities exhibit similar relationships between price and force.
Market moves may be counter-intuitive with respect to currency and economic considerations etc but they are NOT counter-intuitive with respect to the prevailing supply and demand imbalance, and it is that which drives price. The key is to know what the prevailing supply and demand imbalance is and then you know what the price will do. This is what this new use of MFA achieves - it determines the prevailing supply and demand imbalance.
The lower half of Figure 6 repeats what was shown in Figure 5 except on a zoomed-in scale of 2000-2009, which is the present bull market in gold. The upper part of the figure shows the departure from equilibrium (DFE) which is the percentage departure of the actual price from the equilibrium price (EQP). Simplistically speaking there is a “sell zone” between the solid red line and the dashed red line and a “buy zone” between the solid green line and the dashed green line. It can be seen that the major interim tops of 2006, 2008 and 2009 are easily determined as shown by the red arrows. There are also some major entry points shown with green arrows (for clarity not all buy and sell points are indicated).
Forecasting future price changes is done by first of all examining the MFA chart of figure 1 to determine the primary trend of the market. Then the ERA forecast chart is generated (Figure 7 shows a sample chart). The upper segment of the chart shows two proprietary oscillators. The ERA (red curve) is derived from the departure from equilibrium (DFE) explained above and the OSC1 (blue curve) is a complimentary oscillator to help confirm the short term price forecast. While our analysis techniques are multi-faceted the price forecasting essentially centers around the rise and fall of the ERA curve, while trading points are determined by it reaching extremes. The central segment of the chart shows the 15 day price forecasts. These were generated in “blind tests” on the historical data looking only at the ERA and OSC1 and without any price data. A “buy” and a “sell” trade are shown as indicated by the green and red arrows (not all likely trades are shown to maintain clarity).
The lower segment of the chart shows in bar format the actual price change in percentage terms over the same 15 day period as the corresponding forecast that is indicated by the dot vertically above each bar. In forecasting the direction of short term price moves (15 days) that were greater than 3% the ERA returned over 90% correct calls.
The track record we have achieved with our existing proprietary techniques has been extremely good but we are confident that MFA-ERA analysis will bring even more precision in identifying short term trends and the appropriate trading entry and exit points.
Potential Energy – What is it?
When we look at any security we only look at the closing price. Our hypothesis in developing the Potential Energy (PE) indicator was that the intraday data that we throw away must have useful information about the interaction between buyers and sellers. If a stock is going to have a good bull run we would expect it to open near to its lows of the day and close near to its highs. This would be high potential energy. If a stock is going to have a sustained bear market we would expect it to open near its highs each day and close near its lows. This would be high negative potential energy. So this is what potential energy indicates: how well is the stock performing intraday with respect to its potential. Both the Premium and Standard Gold & Silver MFA subscription reports contain an analysis on the HUI – AMEX Index of Unhedged Gold Mining Companies.
Potential Energy (PE) Applied to the HUI
Figure 8 shows the PE (blue line) for the HUI (black line). The 50 DMA of the PE is also shown in red and the 15 DMA in green.
There are some astonishing properties of the analysis: