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Supply, Demand, and Stocks

In my experience, supply and demand aren’t explicitly discussed very often when talking about investing. But changes in demand for a stock–or, more relevant to index investors, demand for stocks in general–are of tremendous importance.

Over any period, the return from the stock market is determined by three factors:

  1. Changes in the market’s P/E ratio,
  2. Earnings growth, and
  3. Dividend payments.

And the first of those factors–the market’s P/E ratio–can be thought of as a measure of demand for stocks. The more people there are who are interested in owning stocks, the higher the market price for each dollar of earnings.

Supply and Demand Over Short Periods

Over short periods, changes in demand (and thus P/E ratios) are the dominant factor in market movements.

  • When investors get scared, demand for stocks drops. The (relatively) modest positive return from dividends and earnings growth gets absolutely crushed by the effect of the P/E decline.
  • When stocks become trendy/sexy (think late 90s), demand increases, causing market returns far beyond the fundamental return earned by the underlying companies.

Supply and Demand Over Long Periods

Shifts in demand can play a significant role in determining long-term market returns as well. (It is worth noting, however, that their significance relative to dividends and earnings growth is far smaller over long periods than over short periods.)

For example, as Frank from Bad Money Advice recently reminded us, the mainstream acceptance of stocks as a worthwhile investment coupled with the rise of the mutual fund fueled an increase in demand that resulted in fantastic market returns from the 60s through the 90s. He notes,

“The stock market of today is not the same as the market of fifty years ago. It’s role in the economy and in our culture has massively increased. That change brought on a secular rise in the valuation of the market. And that rise is unlikely to be repeated over the next fifty years.”

Demand for Stocks in the Future

For the last several years, many people have been predicting that the market’s returns will be suppressed over the next few decades as the Baby Boom generation moves through retirement, slowly but steadily selling off their assets (and decreasing aggregate demand for stocks in the process).

Others–like Jeremy Siegel in The Future for Investors–argue that increasing investment demand from developing economies (particularly China and India) will make up for the reduced demand from U.S. investors.

How You Can Benefit

It’s only natural to try and surmise a way to benefit from such demand shifts. But I’d caution against getting too clever.

Unless you can foresee a big demographic/demand shift prior to the rest of the market figuring it out, there’s really not much you can do. As with other attempts to beat the market based on any particular piece of data: If it’s obvious, it’s worthless.

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Comments

  1. Great explanation – you’re right, many times supply/demand isn’t factored enough in relation to stocks.

    We may very well be seeing the beginning stages of a seismic shift in demand of investments from US to China & India as their middle class gets larger and more people look for invesments there.

  2. Rob Bennett says:

    Unless you can foresee a big demographic/demand shift prior to the rest of the market figuring it out, there’s really not much you can do.

    The overall article is fine stuff, Mike. This particular statement does not hold water (in my view!).

    You don’t need to anticipate a demand shift to profit from it. The demand shift evidences itself in the P/E10 level (valuations). An increase in the P/E10 level causes lower returns on a going forward basis. That’s the information you need to act on. All you need to know to become able to invest more effectively than Passive Investors is that valuations affect long-term returns. You don’t need to guess about anything. You just look up the P/E10 level and make whatever allocation changes are needed in response.

    As with other attempts to beat the market based on any particular piece of data: If it’s obvious, it’s worthless.

    This claim assumes investor rationality, Mike. If investors were engaged solely in the rational pursuit of their self-interest, this would indeed follow. But this is obviously not the case. If investors were engaged solely in the rational pursuit of their self-interest, valuations would never get to the insane levels that applied from 1996 through 2008. The reality is that they did get to those levels and they remained at those levels for 13 years.

    The Passive Investing model assumes investor rationality. This is its great flaw. All of the principles of Passive Investing would follow if the premise were correct. But the premise is not correct. It is the P/E10 level (the valuation level) that tells us at any given time how irrational we have become in our investing decisions.

    Thanks for addressing an important question and for offering your sincere take on it for the edification of us all. That’s how a Learning Together process begins.

    Rob

  3. P/E is one proxy for supply and demand for stocks, certainly.

    The yield curve can also give clues. When investors are flocking to safe assets and pushing down short term rates (like now, give or take quantitative easing! 😉 ) it suggests bonds are still much more in demand than stocks.

    The $3.5 trillion sitting in US money market accounts also suggests demand for stocks is low. (You can compare it as a percentage of the value of the S&P over time for more clues to demand etc).

    Cheers!
    M.

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