Consulate U – Class 3 – Supply and Demand
The law of supply and demand serves as one of the most basic founding principles of economics. Supply ideally should equal demand, and the price of goods or services is what brings supply and demand into equilibrium. Too little supply and robust demand will send prices soaring, but too much supply and weak demand will send prices plummeting. Most investors comprehend the simplicity of supply and demand; however, the complexity lies in determining what market catalysts will trigger increases or decreases in supply and demand. Just when you think you have it figured out, supply and demand will surprise you, which is why an investor must fully understand the asset in which he or she is investing.
Everything that you buy and sell—be it for consumption, services, or for investment purposes—is subject to the forces of supply and demand. Government and corruption, however, are two forces that can throw a proverbial wrench into the equation of supply and demand. If corrupt individuals manipulate supply or demand, then prices will adjust accordingly, despite the illogic of the situation. If a government attempts to intercede in the forces of supply and demand for the supposed good of the public, then you can be sure of an unjustifiable outcome. As a result, although all investments should be regulated by the invisible hand of supply and demand, a watchful eye must be placed on government intervention and other unnatural forces.
When the virtues of gold are touted in an advertisement, the serious investor might consider the principle of supply and demand and question whether the demand for gold will actually skyrocket. When a stock is touted as a “sure thing,” the serious investor is often quick to consider supply and demand. A wise investor will determine a company’s revenues and earnings and question why such a stock might solicit high demand.
Perhaps without even being aware of it, most of us apply the principle of supply and demand when considering whether to make a personal purchase. We may wonder whether a popular consumer product will come down in price if we just wait a little longer before purchasing it. (How long to wait before buying a product is another element to consider). When a prudent business person starts or expands a new business, he or she will contemplate supply and demand, examining whether there will be a strong demand for his or her products or services and whether there are other competitive forces that may thwart long-term prospects. When buying a new home, a person may consider the re-sale value (i.e., demand) of the house by determining whether the home is located in a good school district, assessing how many new homes will be built in the area, and considering whether the house is located in a safe and attractive geographic location.
What increases demand for a stock? Growth—or the expectation of growth—in revenue or earnings is the most common reason for increased demand, but other forces can also increase stock demand. For example, a company may have a strong record of increased earnings or revenue for years, but if a buyout of the firm is anticipated, then additional demand can grow. An acquisition of an entire company normally sells at a much higher stock price compared with current trading values.
What decreases the supply of a stock? This normally occurs through what is called stock buybacks. Many companies have strong cash flows but lack new investment possibilities, which leaves them with two choices: Pay their stock investors dividends or initiate stock buybacks. In theory, stock buybacks are the better way to pay investors compared with paying dividends. The thought is that by decreasing the amount of stock, the price of the stock will adjust accordingly to the reduction of the outstanding shares. Stock markets, unfortunately, are not always that rational. What truly increases the supply of stock—and what an investor must monitor—is the amount of stock given as compensation to executives of the company.
What increases supply and demand of a commodity? Commodity supply and demand is easy to understand but extremely difficult to predict. The demand for commodities can fluctuate wildly, and the supply can be just as unpredictable. Manipulation of commodities is simple, for example, how OPEC (Organization of Petroleum Exporting Countries) can control the supply of oil. Supply and demand for commodities can be influenced by weather, politics, disease, fungus, labor issues, and many other uncontrollable forces.
Bonds and the interest rates offered on bank accounts, certificate of deposits, treasury bonds, corporate bonds, and mortgages are at the mercy of supply and demand. Interest rates can be manipulated by the Federal Reserve, as proven during the 2008 economic downturn, but usually it is normal market forces of supply and demand and inflation that cause rates to rise or fall.
Inflation is a direct result of supply and demand. Greater amounts of disposable income across large numbers of people (demand) who make purchases from the supply of goods available normally causes inflation. Inflation is also the percentage increase (or decrease) of the cost of goods as measured over a 12-month period. To put it in perspective, why would you lend money to someone at an interest rate less than the expected cost of goods? For example, goods worth $1,000 today may cost $1,020 a year from today; thus, a lender would charge at least 2% interest on a loan.
Even healthcare is driven by supply and demand. The typical high salary paid to doctors is reflective of the low supply of such medical practitioners given the rigorous educational requirements to become a licensed doctor. As a result, the demand for doctors is enormous, which creates an environment for outsized compensation. The supply of doctors and medical resources is limited, yet the demand for the profession and its services is almost unlimited.
Many countries struggle with how to provide advanced, but cost-effective, healthcare to their citizens. Too many politicians, however, ignore the supply-and-demand equation and instead promote a seemingly simple solution that is rooted in a covert political agenda. The true law of supply and demand does not succumb to politics, but a poorly constructed political solution will succumb to the laws of supply and demand. Government and/or money may rule over supply and demand to force these entities into equilibrium, and the citizenry may suffer as a result of it. Our governments, prefer to develop political bases rather than honestly debate and develop a functional healthcare system embedded in the law of supply and demand, which would benefit everyone.
A smart investor is mindful of the creation of false demand for stocks or investments. If an investment is not worth funding, then sales people are often incentivized to create false demand in an effort to sell the investment. Insurance companies and brokerage firms are notorious for sales people who create an impression of false demand around the products they sell. When investing, ask the representative who is attempting to sell you the asset whether he or she receives a commission from the sale. If so, then there are probably far better and more cost-effective investment opportunities that are more apt to benefit you, the investor.
It is critical for all investors to understand the law of supply and demand. By doing so, one can better appreciate why well-established company stocks will be and have always been good long-term investments. The world economies need to continue to thrive if the world is to continue to advance into the future. If world economies continue to grow, then revenues and earnings will rise, cultivating a greater demand for stocks. Outstanding shares of these companies are highly unlikely to expand after such firms become established corporations (like the top 5,000 corporations in the United States or the top 15,000 corporations in the world). Holding a diversified pool of stocks (or ETF equivalents) in your portfolio is a logical supply-and-demand bet, but opportunity can arise via many other investments. Searching for such investments while remaining vigilant about potential supply-and-demand imbalances should be the goal of the wise investor.