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The Economics of the Stock Market Pt. 2

Supply & Demand and the Stock Market

First let’s answer the basic question, “What is a stock?” A stock is partial ownership of a business or company.

Companies typically start out as privately held ventures. Joe Smith may start a widget making business in his basement. He sells them to friends and neighbours who tell their friends and soon Joe is doing a booming business.  He opens a store front and the business continues to prosper and grow. It grows so well, in fact, that Joe decides he wants to expand.

When companies want to raise money for research and development, exploration, promotion, expansion or whatever else a company might need money for, they often sell part of the business to the public. In our example, Joe may start by selling an interest in his business to friends and family. This interest is called stock shares. Shares privately held by Joe and his friends and family at this stage are not publicly traded.  They can only be sold by privately negotiating a deal with another investor.

But as the business grows and the demand for capital increases, Joe decides to go public. After going through the required legal stuff, an initial public offering (or IPO) for Joe’s Widgets is launched. The underwriting brokerage makes these shares available to selected clients at a set IPO price. After the offering is complete, the stock starts trading on a stock exchange.

Not all the shares that the company is allowed to issue are sold. The company may just sell some of them and keep the remaining shares “in treasury”.  The shares that are sold and are traded on the public market are called the public float.  The shares in treasury are not traded and do not affect the supply and demand for a company’s stock. But the company reserves the right to sell some or all of these shares in the future through another public offering.

A stock exchange, as the name implies, is a marketplace where people and corporations can buy and sell stock in publicly traded companies. The people handling these transactions are called brokers.

With many buyers and sellers in the market, prospective buyers call up their broker and offer to buy a specified number shares of a specified company at a specified price. For example, Sam Jones may call his broker to ask him to buy 100 shares of Joe’s Widgets at $9.50 a share. Meanwhile, Fred Flint may call up his broker telling him to sell his 100 shares of Joe’s Widgets at $10.00 a share.

If they are the only two people proposing to trade that day, there is an impasse. Sam’s offer is only $9.50 while Fred’s asking price is $10.00. The respective brokers notify their clients of this impasse and Sam and Fred may each decide to meet in the middle, in which case the shares change hands at $9.75 a share.

Some companies, in fact, are what are called thinly traded.  They may go days without any transactions taking place. They are said to be illiquid.  Others are very heavily traded. Major corporations usually fall into this category.  Because there is so much action in these shares, buyers and sellers can opt to buy or sell “at the market”, which means that they buy or sell at whatever the current price is when the deal goes through.

With modern computer technology you can buy stocks over the Internet from an online broker and have the transaction entered and completed within seconds. Some brokers are so confident of their ability to process transactions quickly that they offer to waive their broker fees if they fail to complete your order for an even lot number (multiples of 100) at the market within ten seconds.

Supply and demand are felt in the stock market in a very real bidding war by buyers and sellers negotiating transactions. The key to success in the stock market is to understand the economics of the stock market. It is to understand the factors that affect the supply and/or demand of a stock. So let’s look at those factors.

The Economics of the Stock Market

Ultimately, the value of a stock is determined by the potential the company has to bring in profit. It is this, and this alone, that drives a stock’s price. What that potential is, however, is always a matter of opinion tempered by fact. And opinions differ and change.  Hence stock prices change.

The same laws of supply and demand apply to stocks as to anything else, even though stocks are not “consumed” in the sense other goods and services on the marketplace are. If the supply of a stock goes up (shifts to the right), the value of the stock will fall, all other things being equal.  If the supply drops, the price goes up.

On the demand side, if the stock becomes more attractive to investors (increased demand), the stock goes up in price.  If investors lose interest, demand falls and so do prices.

As with goods and services, other things are never equal.  So here are the factors that affect supply and demand for stocks:

Supply

• If a new share offering is conducted to raise additional capital, this increases the supply of shares on the market.
• If employee stock options are granted, this has the potential to increase the supply of shares when the options are exercised.
• If a company has a stock split, this increases the supply of shares on the market.
• If a company buys back its shares and cancels them (a normal course issuer bid), the supply of shares decreases.
• If a major shareholder liquidates a major portion of his or her personal shares, this has the effect of increasing the supply of shares on the market, though strictly speaking, these shares were already part of the public float.

Demand

Demand for a stock is affected by a number of factors:

• If profits reported are greater than expected, demand increases.
• If profits reported are less than expected, demand decreases.
• If the company is not profitable, expectations of profit are what drives demand.
• Sales are also drivers of demand. Important new contracts will send demand up while shortfalls in sales will send demand down.
• The company’s debt load can affect demand. If the company takes on too much debt, demand could fall if the public believes the debt to be unmanageable.
• News about a company can change the demand for its shares. Good news increases demand. Bad news lowers demand. As a good news example, demand for shares in a drug or biotechnology company will increase if the FDA approves one of its products. An example of bad news could be a mining company reporting that a core drilling program turned up empty.
• Mass psychology can play a huge role in demand. Individual stocks as well as whole markets can move quickly if there is a general belief among investors that the stock or the market will go up or down even if there is no rational basis for such movement. Extreme movements to the upside are called bubbles. Extreme movements to the downside are called panic selling.

Mass psychology is characterized by the concepts of fear and greed. These can be augmented by real life events unrelated to the market. For example, the tragic events of September 11, 2001 sent the market crashing with the Dow Jones Industrial Average suffering its sharpest weekly decline since 1933, the second worst since 1915, as it plunged 14.3%.

These are just some of the factors affecting the supply and demand for stocks. The interesting thing about stocks, though, is that the inter-relationship of supply and demand can be graphically depicted by stock charts. And a whole science called technical analysis has sprung up. Technical analysts believe they can predict future movements of a stock based on past movements, at least in the short term.

The reason technical analysis can be an effective tool is because stock charts are dynamic snapshots of the law of supply and demand in action. Every change in price and volume represent shifts in supply and demand and the setting of new equilibrium levels.

And sometimes these shifting equilibrium points tell us a great deal about the make-up of the mass of buyers and sellers in a particular stock.

Why do they change? The reasons cited above are certainly a factor, but there is also another dynamic. The buyers and sellers themselves are also a factor in the mix.

Consider this hypothetical case: The previous day’s closing price for Joe’s Widgets was $10. As the market opens the next trading day, there are 100 people interested in buying 100 shares each of Joe’s Widgets. And there are 100 people interested in selling 100 shares each. But these buyers and sellers are not a homogenous lot.

With the sellers there are ten who will not accept less than $10 a share. There are another fifty who will not accept less than $10.25 a share. Another twenty-five want at least $10.50 a share. Ten more are adamant about getting at least $10.75. And the last five want $11.

With the buyers, there are no buyers willing to pay $11. There are fifteen willing to pay no more than $10.75. Another twenty-five are willing to pay $10.50 but not a dime more. Twenty more won’t pay more than $10.25. Thirty are willing to pay the $10 price of the previous close. And the last ten are bargain hunters who will pay no more than $9.75.

As the day progresses and trades are made, the supply and demand for the stock shifts as buyers and sellers are satisfied. The unsatisfied traders make up a new mix. Here is how the trading might go.

The ten bargain hunters who are willing to pay $9.75 are unable to find sellers. Their orders go unfilled until they are willing to raise their bid. Ten of the thirty willing to pay $10 get filled. The other twenty cannot get filled until they raise their bid. The price quoted on the market is $10.

But there are twenty who are willing to pay $10.25. Their orders are now quickly filled and the quote goes up to $10.25. The next twenty-five buyers who are willing to pay $10.50 find they can actually get the stock for $10.25 and get filled at that price. And five of the fifteen willing to pay $10.75 get a real bargain at $10.25.

The $10.25 sellers are now exhausted and the ten remaining buyers willing to pay $10.75 get filled at $10.50. The last quote is $10.50.

The remaining sellers are asking more than the buyers are willing to pay and the remaining buyers are willing to pay less than the sellers want. There is an impasse and unless new buyers and sellers enter the market or existing interested parties change their bid, trading will stop.

You can see the dynamic here as the supply and demand shifts. Seeing that the stock is rising, some recalcitrant buyers may up their bid. Depending on their eagerness to sell, some of the sellers may lower their ask price.

Looking at a chart of past price action, we can sometimes pick out patterns. Perhaps at $12, Joe Widget shareholders start selling and taking profits. The upward pressure on the stock price peaks and it starts going down. At $9.75, bargain hunters start flooding in and snap up the available stock, and the price starts moving up again.

The alternating peaks and troughs of the trading action can be analysed to determine what are called support and resistance levels. At a support point, buyers jump in to grab bargains. At a resistance point, sellers jump in to take profits.

Part 1: Understanding the Concepts That Move the Market
Part 3: What the Charts Tell Us

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