When looking at securities markets, we generally think of them as being fundamentally driven, meaning that the value of a security will be based upon its so-called value. Since people put a lot of weight on this sort of thing generally, it is important to be clear on what really drives securities prices, and the reality can be quite different from what we think it is.
The two most popular ones that investors own are stocks and bonds, and they operate quite differently indeed, so we have to make a big distinction between them when looking at what influences their prices.
Bonds are the easiest of the two to figure, because bonds change value mostly from changing interest rates, since they are interest-bearing instruments essentially. While the supply and demand for bonds does factor into things somewhat, and if more people wanted to invest in bonds their price does rise, this rise is quite limited in potential due to the restraining forces of interest rates.
This is why we don’t see big spikes in bond prices during periods where a lot of money moves out of stocks and other investments and into bonds. More people may want to own bonds, more institutions may want to invest more of their portfolios in them, but only to the point where the price is fairly closely related to their fundamental value.
With bonds, the lower the price, the higher the yield, and these two elements are intertwined. A bond issuer will only want to borrow at a certain rate, a certain amount over the LIBOR rate we’ll say, which will depend on the creditworthiness of the issuer as well as competitive forces in the debt market, which bonds are a big part of.
Traders may trade these bonds among themselves, and this happens a lot, and since the yield is generally set, what will fluctuate is price. Price and return together create the yield, and yields can go up with more demand, but only to a certain point.
This is a lot like looking for a loan from different sources, where the rates may fluctuate among them but at the same time they will not differ by that much, because lending money to you is going to have a floor and a ceiling as far as the reasonable range for the lending.
We therefore will see bond prices and yields move within a certain range relative to where interest rates are, but these underlying rates will always have their say and control the market very significantly.
Of course, we could still speculate on bonds by trading them, and the price does move enough that we could use plenty of leverage and potentially profit quite a bit, and there are a lot of bond traders that do very well indeed. Investors, on the other hand, are usually looking to keep them for several years or longer, and therefore really don’t do much market timing, so price trends aren’t going to matter to them much anyway, and most of the changes in price with bonds are not driven by supply and demand so much but by macroeconomic factors.
Supply and Demand with Stocks
Stocks are a whole different animal though, and the price of stocks is almost entirely dependent upon the forces of supply and demand. The only real fundamental restraining force upon stock prices is the concern that some investors have if the price gets too out of line with business fundamentals, things like price to earnings ratios and such.
We could say though that even this is a matter of supply and demand, where low ratios may create more demand, and higher ones may lessen it from the effect of these concerns. Apart from that, stocks are just as much a product of the market as Dutch tulips were, or more recently, cybercurrencies are.
Cybercurrencies don’t have any underlying value, or correspond to any physical entity, and they derive all their value from what people are willing to buy and sell the currency for. Stock value operates very similarly to this, and contrary to what most people believe, are only worth the amount that they can be sold for in the market at any given time.
Even in cases where the company goes out of business and you are still holding common shares of it, by the time the creditors are paid, including bondholders and preferred shareholders, there will probably be nothing left and your shares may not be worth the paper they are printed on, or in today’s situation, the disk space that they occupy on computers.
The market decides the price of stocks, not mostly, but entirely. The only exception to this is initial public offerings, which are offered at a set price, but after the shares are issued, the market takes over completely and retains full say for the life of the stock.
Not appreciating this enough can lead us well astray, because it can have us putting way too much focus on fundamentals and not enough on the market itself, especially the market as a whole. While microeconomic fundamentals can tell us how the company is doing, its likelihood of staying in business for instance, they can’t tell us all that much about where the price is headed, because it’s the supply and demand itself that speaks here.
Supply and demand affect stock prices directly. When we quote a stock price, we are quoting the result of stock trades, and the current price is the last one traded at in the market. There are many things that go into determining the magnitude of this supply and demand, but it really all just comes down to how much money is on the buy side and on the sell side at a given price.
When there’s more demand than supply at a given price, the price will rise, and those who hold the stock will also see this and respond accordingly, raising their asking prices as more orders to buy come in or may be expected.
When the price goes up, sellers will naturally raise their asking prices, and provided that there is enough demand at this higher price, it will trade higher. The opposite happens as the price declines. This creates momentum, and is why stocks do move in discernable patterns in both directions.
There are no natural limitations to how high we can go, and we’ve seen stocks with extremely high price to earnings ratios traded, and some with infinite ratios as they haven’t earned anything yet but the price gets shot up very high.
This is not unlike what happened with bitcoin and other cybercurrencies, there is no intrinsic value present at all with them, but as long as people are willing to pay more the price will go up. When the money dries up and things start going in the other direction, this creates downward momentum and we can see some big drops.
When the stock market crashes, people are afraid to buy and eager to sell and by the time the dust settles, our stocks may have lost half or even three-quarters of their value, and it doesn’t really matter if the fundamentals have changed or not, people are moving money out of the market and the market must go down when that happens, without question.
If we just spend our time poring over company reports and such in order to look to predict a stock’s future price, we are left to ignore what is the most powerful force in stock prices by far, and actually the only real force, which is supply and demand.
How We Might Use this Information
Knowing the real reason why prices of investments move allows us to make much better decisions about our investments than we would otherwise. The key word here in doing this is momentum, and the only reason why understanding the role of supply and demand with stocks is to distinguish how the momentum that this creates moves prices.
This can then be used to help predict stock prices, not in the distant future but where the price is trending at the current time. While we can measure trends with various timeframes, for instance where it’s going minute by minute or even second by second, or month by month or even year by year, the process is the same, we look for signs of market direction, which means the trend of the forces of supply and demand.
Regardless of what our view of stocks are, we know for certain that any factors that go into the decision about the price of these stocks, by the trading participants anyway, is factored into the price. That’s the beauty of exchanges, as we don’t have to speculate or predict where the price is, the market simply sets it based upon the trading that occurs, where buyers and sellers come together and reach equilibrium.
This last traded price isn’t really that significant by itself, but when we combine them with trading prices that preceded it over a given period of time, we can indeed gain some insights as to where the market for something is heading.
None of this is exact science of course, it is all really about probabilities, the chances of something going up or down, and even how much up or down they may move.
Being in investments requires an evaluation of its prospects when purchasing it, as well as an ongoing assessment of its prospects, and this is the part most investors don’t bother to take advantage of.
They may think that there’s nothing that can be done here, or that this sort of thing isn’t really that predictable, or they may think that since they plan on holding this anyway for years, where it goes on its journey there doesn’t matter.
None of this is actually true though, and we can indeed profit from evaluating changes in supply and demand and use that in our investment decisions, and in particular, use this to look to avoid situations where we’re more likely to lose money than make it.
With bonds, we’ll be mostly looking at interest rates if we look to time this, but we can get some good data from charts as well, as trends in interest rates will be followed by trends in bond prices. Big bond traders also tend to be the best experts when it comes to analyzing macro trends and predicting these things, and therefore we can’t go too far wrong going with the trend with bonds and showing more restraint when the trend is not moving in our favor.
Regardless of how long we plan to invest, we owe it to ourselves to at least try to understand the things we invest in better, and especially not to just accept what most people may think about them, leading to their being opposed even to think about such things as playing in active role in managing their portfolio or even doing anything beyond perhaps switching funds.
As they say, the price does tell all, but only if we’re willing to listen closely enough.