The stock market is a function of supply and demand. Now that we have covered that we can move on…. Whoa, hold your horses there cowboy. Yes, the markets are a function of supply and demand, but in my experience very few investors understand the mechanics of the above statement or the very powerful implications of it.

First let’s talk about the mechanics of supply and demand in the markets. In the short-term stock supply is relatively fixed. Initial public offerings (IPOs) and new stock issuances take a great deal of time and effort and are announced well in advance of the action occurring. Therefore over the next 12-18 months it is very hard for there to be big unexpected shifts in stock supply. Since supply is relatively fixed in the short-term, demand is the great driver of stock prices over short-term periods. Demand tends to change very rapidly and is very sentiment based.

Over the long-term supply curve pressures overpower demand curve pressures. Stock supply can expand or shrink boundlessly over the long-term. Supply is increased through issuances and shrinks through buybacks and cash or debt-based takeovers.

When demand for a category of stocks becomes very low and prices fall it leads to increased buybacks, mergers, and acquisitions which destroys supply and eventually will lead to higher prices. We saw this with the financial sector in 2008 & 2009, and have been witnessing it more recently within the energy sector.

Conversely when a category of stocks becomes in very high demand, usually because of recent strong performance, new supply will be added until it eventually dilutes future returns. We saw examples of this within the technology sector in the late 90s moving into the 2000 bear market and with the run up in emerging markets prior to the financial crisis.

Investment bankers make money by facilitating new stock issuances, buybacks, mergers, and acquisitions. Often times they are seen by the public as mysterious boogeymen, but their work enables the stock markets to be a very efficient function of supply and demand.

Understanding the principle of supply and demand as it relates to stock markets should help an investor to properly diversify their portfolio and avoid “chasing heat” (falling in love with a category of stocks because of recent strong performance).

 – Wyatt Swartz

5/23/2017