With the third quarter behind us it is not time for…DUN, dun, DUN…Q3 earnings reports!

As we preach markets are just reflections of basic economics, and to over simplify that we just need to look at basic supply and demand to understand markets. In the short and near term markets trade on technicals, which is to say that news, systems, charts, and rules are embedded into trading philosophy and trading algorithms and those technicals move markets and prices. The other force that moves markets not only in the short and near term, but more importantly in the long term is fundamentals (economics). As we enter Q3 earnings reports it will be fundamentals that will be on display and moving the markets in the coming weeks and months.

Governments, central banks, traders, the media, and algorithmic systems can only do so much to move markets up and down; it is the laws and forces of supply and demand that cannot be broken and what ultimately move markets. Commodities are true supply and demand markets; producers provide supply and consumers demand those products.

Technical events provide volatility, but it is fundamentals (economics) that drive long term trends. It is not breaking news; commodities are in a long-term downtrend. Short term technicals (news, fiscal and monetary policy, speculation, ect) have provided recent lifts to markets and the commodity sector. Earnings of firms will give us the all so important fundamentals (economic) snap shot to look at the big picture…Will more or less be demanded, will more or less be supplied, and will long-term price trends be looking up or looking down?

China, Japan, and Germany have all had falling monthly PMI numbers, and their weakness is weighing on earnings of firms with global exposure. The technicals and fundamentals of the global economy and firms have been pumped up by trillions of dollars in fiscal and monetary stimulus since the financial crisis. The terrible US Jobs Report on October 2nd saved the market as it was so bad it was good as traders predicted more stimulus (and cheap interest rates) will keep/get business flowing.

Global data has been painting both a technical and fundamental picture that world economic output is slowing. On October 6, 2015 the IMF cut the global growth forecast for the 4th time in the last 4 quarters, and the current forecast of 3.1% is the lowest global growth rate going back to the financial crisis. Nowhere is the concept of the global economy and growth more evident than in declining corporate profits (see FRED earnings graph).

While technicals can move prices, at the end of the day techinals cannot replace the fundamentals (economics) of global trade and profits of firms.

Markets, traders, and firms can find ways to manipulate technicals and even earnings through such things as mergers and acquisitions and stock buy backs, but real earnings fundamentals (economics) are either growing or shrinking. US corporate profits are basically flat and shrinking.

Through technical trading the markets have been extremely volatile the last few months, again as we preach uncertainty drives fear, and fear drives volatility. As firms reports earnings uncertainty will become fact, either earnings and demand was up or it was not, and the markets can get back to trading on fundamentals.

Since commodities are more truly supply and demand based (economics based) than equites and bonds, the commodities sector tends to trade more on fundamentals. At the end of the second quarter we asked the question, Are Commodities Pointing to a Global Recession? Commodities tend to be a leading indicator, falling prior to recession. Commodities are a direct reflection of the global economy, and as prices continue to fall, there is no surprise that the world economy is starting to cool and we may be nearing the end of the business cycle.

If you compare the business profit graph to the falling commodity graph it paints a fairly obviously picture, falling commodity prices lower firm profits, and low firm profits cause recession.

At some point firm level profits reflect the reality, and not the indicator. Something has to give, either firm level profit start catching up to market valuations, or market valuations have to come down. Cheap commodities are good for individuals and firms that consume, but deflation sucks the life out of profits. Third quarter earnings will determine if profits have caught up with valuations or it fundamentally firms are overvalued and prices need to further correct down.

Uncertainty drives fear, and fear drives volatility, but when uncertainty become fact a whole new type fear can set in. Earnings reports from Q3 will soon become fact, and third quarter earnings will tell us if the truth is a scary place.