Don’t Forget “Supply” & “Demand” As A Driver Of Stock Prices
Don’t Forget “Supply” & “Demand” As A Driver Of Stock Prices by David Robertson – Real Investment Advice
The stock market’s roller coaster ride this year is beginning to cause a certain amount of apprehension among investors. What has prompted the recent weakness? Is the recent decline just another bump in the road or the beginning of a prolonged downturn? Should adjustments be made to the portfolio?
Most financial analysis focuses on factors such as cash flows, growth expectations, and balance sheet strength, and rightly so. The relevance of these factors to asset prices is strongly supported by both theoretical and empirical evidence. Yet one of the most basic tenets of economics is that price is a function of supply and demand. While investors tend to hear a lot less about the supply and demand for stocks themselves, this relationship can also have a meaningful influence on prices.
In order to fully understand the supply/demand dynamics for stocks, it is important first to remember the difference between primary and secondary markets. In primary markets, a good is manufactured or provided and a price is established by the provider. Those providers make their best estimates as to what the prices should be. In secondary markets, a pre-existing good is traded. Price is determined by the interaction of buyers and sellers as the point at which supply equals demand.
A common misconception is that stocks are priced like primary goods (which is only true of initial public offerings).There is a price for the product, you decide to buy or sell it, and that’s that. You either have the stock or you don’t. Such thinking is often enabled, if not encouraged, by the financial media. For example, the Financial Times reported [here] (in regards to bonds, though it is just as relevant for stocks),
“Investors have pulled almost $6bn out of corporate bond funds in the past week, in the latest sign of nervousness about companies’ debt pile in an environment of rising US interest rates and falling oil prices.”
Financial securities like stocks and bonds, however, are normally priced in secondary markets. This means that when a stock is bought or sold, it is really exchanged between the buyer and seller. The price is established by determining the price that clears the market, i.e., balances the demand from buyers with the supply from sellers. As John Hussman instructs [here],
“[O]nce a security is issued, whether it’s a government bond or a dollar of base money [or a share of stock], that security must be held by someone, at every point in time, until that security is retired.”
Therefore, while the statement about bond funds is true, it is also true that “investors have added $6bn into corporate bonds in the past week”. Why? Because when owners of mutual bond funds sell shares, the mutual fund company generally needs to sell bond holdings, and when they do, some other investors need to buy those bonds. As a result, the story reveals very little about whether corporate bonds should be bought, held, or sold. It only reveals the behavior of investors in corporate bond mutual funds, which is only one subset of the universe of all of investors.