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Thursday, 19 November 2009

Understanding stock movements


THE most popular phrase that stock market commentators use to describe rising prices is 'bargain hunting' and when the market falls, we often hear it was because of 'profit-taking'. Sometimes, these variations are used - 'demand was greater than supply' or 'there were more buyers than sellers in the market'.

But do stock prices really rise because of bargain hunting or fall because supply exceeded demand? Or is the use of these descriptions nothing more than commentators and analysts taking the easy way out and not wanting to think through the real reasons why the market moved the way it did?

Equating buying with rising prices and selling with falling prices is actually wrong because the two activities are two sides of the same coin. For every transaction done in the market, there has to be an equal number of buyers and sellers; the absence of one set of parties means no transaction takes place. If no transaction is concluded, then prices do not move.

What actually happens when prices do move is that shares have been exchanged among investors whose opinions and expectations have changed about the market or the companies concerned.

Rises and falls

For instance, prices rise because investor expectations have become positive. It may be that the company has announced a big, profitable deal. Or perhaps the government has just announced an upgrade in its economic forecast that could directly benefit that particular company.

Investors will then pay a higher price for stocks which they think will be later worth more.

Conversely, prices fall because investors have reversed their outlook and are willing to transact at lower prices. Their outlook for that stock or the market as a whole has changed to negative.

Similarly, saying that 'demand was greater than supply' to explain a price rise is wrong because stocks do not follow the traditional demand-supply frame work.

In a perfectly competitive market, demand for goods will be more when the price is low and less when the price is high. For example, a cell phone or a pair of shoes will sell in greater quantities if it is priced at $100 instead of $500.

Stocks, however, do not follow this predictable pattern. For example, when Creative Technology's shares fell to $5 during the regional crisis six years ago, analysts called a 'sell' on the counter.

When it rose above $60 a few months later, everyone said it was a 'buy' and the price duly rose to $66. In other words, demand for stocks is different from demand for any other goods that we know of and people will chase prices higher and higher. Recall the Internet boom of 1999-2000 and the fact that stocks rose by huge amounts, by as much as 40-50 times. Those same stocks either do not exist any more or trade for a fraction of their previous prices.

In his 1938 book The Theory of Investment Value, Harvard professor John BurrWilliams said: 'When the price of a stock moves, it moves because the demand curve moves, not because the quantity demanded changes.' A shifting demand curve is indicative of shifting preferences and, perhaps, sentiment.

Misleading phrases

What about the classic 'bargain hunting' and 'profit-taking', two phrases which convey no useful information to the reader or listener and whose common use actually mislead rather than informs?

Consider, for example, 'profit-taking', a phrase which implies falling prices because investors were cashing out. But what about those who bought? Presumably these buyers want to make money later, so why not say prices rose because of 'profit-making'?

Similarly, 'bargain hunting', which implies people bought because the items were cheap. However, the sellers obviously didn't think the stocks were bargains when they sold, so why focus only on the buyers?

The fact is that most of what we hear and read about markets today is misleading and is based on the wrong use of economic concepts. Stocks don't move because of demand exceeding supply or because people indulged in profit-taking or bargain hunting, they move because expectations change about the future.

They also move because greed and fear are present in differing quantities at any one time. Sentiment is the single most influential factor at work behind price movements. The sooner everyone recognizes this, the better.

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