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Common Stock Investing Part II:  The Supply/Demand Balance and Stock Prices

Common Stock Investing Part II: The Supply/Demand Balance and Stock Prices

In the last article in this column, I reviewed the terminology which surrounds the world of common stock investing. I have been very surprised by much of the feedback on that column, through which people have told me how helpful the column was. Many had heard of the numerous terms we defined; just as many had no idea what much of the terminology meant until they read the column. Armed with a greater degree of knowledge concerning common stock investing, they have asked “what are the next steps.” Even if you choose to rely on a financial advisor, a broker, or a mutual fund representative in order to select specific investments, it is very important to understand what they are trying to do on your behalf. Your decision making will be far more effective, and you will feel much more confident about your investments if you play a significant role in building your portfolio.

In this column I offer some perspectives on what moves stock prices in order that the reader can achieve that higher level of confidence when making investment decisions either on his own or with the help of an advisor.

Stock Market Theories

There are as many theories about the stock market and the pricing of stocks as there are investors. Ultimately, there is no one theory that can explain everything about the stock market, or about even one stock for that matter. At the most fundamental level, supply and demand in the market determines a stock price just as supply and demand determines the price for almost all goods and services.

In the case of the stock market and in particular common stocks, we need to look at what factors influence supply and demand, and therefore price.

Earnings

Theoretically, earnings are what affect investors' valuation of a company, but there are other indicators that investors use to predict stock price. Remember, it is investors' sentiments, attitudes and expectations that ultimately affect stock prices. Therefore, while earnings, or a company’s ability to make a profit, are at the root value of any stock, other events which affect investors’ decision making process will weigh as heavily on their decisions.

Earnings are estimated in advance by analysts who specialize in using quantitative methods in order to predict what investors can expect from any given company. Their estimates are based on historical data, trends within the specific industry, competition from similar companies, and the impact of the success or failure of companies directly related to the company being analyzed. If the analysis is positive in terms of future potential earnings for the company, chances are the share price will rise accordingly. However, there are other elements which affect the supply demand balance for stocks, and ultimately their price.

Geopolitical Climate: Egypt, Libya & the State of Wisconsin

Other events which invariably affect the supply and demand balance for any particular stock will also affect the price of the stock and therefore the value of your investment. In recent weeks we witnessed first hand the impact of unrest in the Middle East. As tensions mounted in Egypt and the functions of government came to a halt, oil prices skyrocketed and stock prices plunged around the globe. An even more troubling reaction hit global markets as Libya mounted a similar demonstration of unrest and displeasure with the current governing regime.

The average investor reasons that political unrest in this region coupled with curtailment of oil supply and skyrocketing prices for all forms of energy will impact earnings potential for all companies. The result, lower prices for stocks globally. The situation effectively curtailed demand for stocks, and the willingness by investors to sell created huge supply. Once again, supply and demand out of balance in favor of supply, and prices fall.

Domestically, the implications of the collective bargaining backlash in Wisconsin shed doubt on the continuation of an improving jobs/labor situation in the US, and ultimately caused a further decline in the demand for stocks and therefore lower prices.

Fiscal Policy/Government Debt/Interest Rates

Many of my columns over the last couple of years have dealt with the theme “global economy.” In fact the paragraphs above hit squarely on the impact of international events on all markets including our own. In the international arena, possibly the most influential factors on the supply/demand balance for stocks stem from the interest rate policies and the fiscal responsibility shown by the largest economic powers.

It has been clear for some time that both the US fiscal policy and interest rates have unnerved global markets and certainly impacted the supply and demand for stocks. Our national debt has screamed past all previous records, and the Fed has held interest rates artificially low for many, many months. Both of these factors, coupled with similar action by the governments of many of the largest economies of the world, have influenced stock markets and stock values. Interestingly, in most cases, the government policy and intervention in interest rates has raised values of stocks. The question for all investors becomes: how long can this last?

History has shown that it cannot last long. Eventually, interest rates will climb higher in an effort to stem inflation fueled by the loose money policies. As interest rates climb, it becomes more expensive for businesses and everyone to borrow money for operations and potential expansion. Therefore, as money becomes more expensive the ability for companies to turn a profit becomes more difficult, and that impacts stock prices.

Conclusions

Beyond understanding the terminology and the mechanics surrounding investing in stocks, it is important to understand what influences stock values. Simply stated, supply and demand is the ultimate determinant for the value of most things, including stocks. Therefore, to better understand the supply and demand dynamics for stocks, we need to better understand the key elements which impact pricing. Company performance (earnings) will always be paramount in evaluating the potential for any stock investment. At the same time, the external forces of geopolitical events and governmental fiscal policy will always impact stock market pricing, and often the values of some particular stocks more than others. While it has long been the purpose of this column to enable you to more fully control your own financial destiny, you can see why it is often worthwhile to seek the advice of professionals. There are many moving parts which influence the ongoing supply and demand for stocks, and therefore the potential for your success in investing. Don’t hesitate to tap the resources of BCU Investment Advisors or any other investment advisors to help you improve the chances for your success in investing.

©Patrick J. Catania 2010
The views and opinions expressed herein are solely those of the author and do not necessarily reflect those of Baxter Credit Union, its Board of Directors, or its employees. The author is responsible for the content. Readers should consult with, and seek professional advice from their own attorneys, accountants, and financial advisors with respect to their individual financial needs and circumstances.

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