Christopher Carosa with FiduciaryNews.com tapped Charles Scott, an Arizona financial planner, for his ideas on supply and demand in the investment markets.
The Shocking Truth of Supply and Demand in the Markets and the Retirement Saver’s Best Interest
Human nature seeks to fill a void, and if no void exists, human nature invents one. Nothing explains the awful tendency to make investment decisions contrary to their own best interests. While behavioral economics perhaps best explains this human nature, traditional economics suggests tactics they might allow investors not only to avoid the foibles of human nature but to profit from that knowledge.
Retirement savers can best help themselves by using their mind to concentrate on saving. They can best hurt themselves by following their passions in the investing markets. Securities markets, though, are no different than markets for goods and securities. They each follow the same fundamental economic fact – the law of supply and demand. The fiduciary who can effortlessly and clearly explain the mechanism of supply and demand no doubt helps retirement savers embrace their best interests.
“The law of supply and demand simply means how much of a product, good, or service is available and how much desire there is to buy it out in the market,” says Milena Thomas, a professional educator with Master of Science in Finance and Specialization Equivalent in Economics who resides in Franklin, Michigan. “For example, you might notice that out of season fruits, such as purchasing berries in the winter, are far more expensive than in the summer. This is because the supply for this product has dwindled, but demand remains high, so the price rises to ensure that the amount supplied meets the price people are willing to pay for it.”
The constant search for equilibrium between supply and demand stretches across the broad range of activities, from the micro to the macro. “The law of supply and demand is the inherent tug-a-war between what is available and what is needed or wanted,” says Bill Rice, President of MyPerfectMortgage.com in Flat Rock, Michigan. “This tension can exist between a variety of entities from people and companies to countries, and ultimately impacts the availability and price of goods and services. We see this when we have a hard freeze during the growing season for oranges, which damaged orange crops and reduced the number of oranges harvested. Then, the scarcity and price of orange juice is likely to rise.”
What goes on in the grocery market in subtle ways explodes with a fury in the stock market. Every trade, every day, kneel at the altar of supply and demand. “When there are more people wanting something than there is the supply of it, the price to get it goes up – and the opposite is true, too,” says Charles C. Scott, founder of Pelleton Capital Management in Scottsdale, Arizona. “When investors like a particular stock and want to own it, and there is a finite supply of shares, the price to purchase those shares goes up. Demand outweighs the supply. When investors do not like a particular stock and want to sell it, the price will go down because there is more supply than demand.”
According to Investor’s Business Daily, “The law of supply and demand is on display every day in the stock market. Strong demand for a limited supply of available shares will push a stock’s price up. And an oversupply of shares and weak demand will cause the price to sag.”
While the impact of supply and demand certainly exists for individual securities, it is the extreme elements of that same concept that can move whole markets – and something in dramatic fashion. Indeed, the precise nature of these boundary conditions suggest what we might expect the market to do, at least in the near-term. A recent study looked at this and concluded, “There is also a significant difference in the pattern of returns if the downturn in the quarter is the result of a supply or demand shock. Negative supply shocks are found to have an especially large and significant counter-cyclical impact on returns.” (“Equity Returns and the Business Cycle: The Role of Supply and Demand Shocks,” by Alfonso Mendoza Velázquez and Peter N. Smith, Centre for Applied Macroeconomic Analysis Working Paper 22/2013, May 2013)
What are supply and demand shocks? They are sudden and unexpected events that dramatically increase or decrease the supply or the demand. Shocks that increase supply or demand as said to be “positive.” Shocks that decrease supply or demand are said to be negative. Sometimes the same event can have the opposite effect on both supply and demand. For example, rising interest rates induces a negative supply shock to capital. When interest rates rise, the cost of capital goes up, effectively reducing the supply of capital. At the same time, rising interest rates can cause a positive demand shock in the bond market. Higher interest rates make bonds a more attractive investment. This increases demand. (Incidentally, this is why bond prices fall when interest rates rise.)
Oddly enough, interest rate cuts (just like tax cuts and increased government spending) can create a positive demand shock because these policies increase overall demand within the economy. This, in turn, creates the higher demand through an increase in consumption.
When often see negative demand shocks impact the markets immediately (usually quite negatively), although usually for just the short-term. The events that can cause a negative demand shock include large area natural disasters (like hurricanes, earthquakes, or multi-state blizzards), terrorist attacks, or any economic calamity that strikes fear in the populace (a stock market crash, a credit freeze or liquidity squeeze like we had in 2008/09, or a deep recession. Negative demand shocks also arise from fiscal or monetary policies. For example, the fear of a trade war can lead to a negative demand shock.
Supply shocks are almost always negative. The example offered by Rice – a freeze that kills oranges – represents a negative supply shock. The Arab Oil Embargo of the 1970s is another example.
In almost all cases, negative shocks may cause the markets to decline. In the worst case, these headline events create a vicious cycle of negativity that causes investors to panic and may result in sudden market drops. This may explain the unusually quick and short-lived correction experienced in February of 2018.
It’s not like supply and demand stocks only impact the equities markets. “Supply shocks affect the whole yield curve, while positive demand shocks increase mostly the long end of the yield curve on impact and thus increase the slope of the yield curve. Demand and supply shocks account for a large part of the time variation in bond yields. In particular, demand shocks explain more than 80% of the variation in the long end of the UK yield curve.” Kaminska, I. (2008), “A no-arbitrage structural vector autoregressive model of the UK yield curve,” Bank of England Working Paper No. 357.
Retirement savers must maintain long-term orientation regarding their assets. Supply and demand shock and generally easy to identify and often temporary in nature. During these kinds of extreme events, in most cases, doing nothing is the best road to take. It’s been said the ones who made out in the great market drop of 2008/09 were the ones who were too frightened to open their 401k statements. By sticking their heads in the sand, they did nothing. Unfortunately, those that did do something usually did the wrong thing – like selling at market lows when they should have been buying.
Which gets us back to human behavior. It’s a little too complex to explain here (perhaps you can read Robert Cialdinior Scott Adams to learn more on this), but supply and demand shock often bring out the worst in decision making for investors. Astute investors will want to recognize this for what it’s worth: the opportunity to stand athwart the crowds in the market and purchase at cut-rate prices.