Robert J. Stonebraker, Winthrop University
The Joy of
Economics: Making Sense out of Life
Robert J. Stonebraker, Winthrop
University
Demand and Supply Applied:
Buy Low and Sell High
If stock market experts were so expert, they would be buying stock, not selling advice.
.....Norman Augustine
Spam crams my electronic mailbox every week. It comes in waves. Nigerians asking my help in shady international fund transfers, ads for gambling and porn sites, offers for cheap drugs and, recently, "sure thing" stock tips.
Luckily I'm an economist; I know better. Taking unsolicited investment advice ranks right next to juggling loaded guns on the stupidity scale. Corporate stocks are a sensible component of almost any investment portfolio, but speculative trading has flushed countless nest eggs down the proverbial toilet.
What are stocks?
Stocks are ownership shares. Entrepreneurs who need funds to start or expand a business have three basic options. They can pony up their own dollars, they can borrow and go into debt, or they can sell ownership shares (stock) in the venture. If a corporation has issued 100,000 shares of stock and you own 5,000 of them, you own 5% of the corporation. Five percent of its current assets (and liabilities) belong to you. So do 5% of its future profits (or losses).
Suppose that you buy into an initial stock offering and purchase 5,000 shares for $100 each. Your $500,000 goes to the corporation and, as a part owner, your vote will help elect the Board of Directors that oversees what the firm does. You can hold that stock as long as you like, but you also have the opportunity to sell. You can sell privately or, more commonly, sell over an organized stock exchange such as the New York Stock Exchange (NYSE) or the NASDAQ exchange. If the stock has risen in value since your initial purchase, you can make a profit; if the value has fallen, you lose.
Demand and supply
What determines the price of a stock? Demand and supply. As in any other market there is an equilibrium price where the quantity demanded equals the quantity supplied. Any higher price creates an excess supply that will drive the stock price down. Any lower price creates an excess demand that will drive the stock price up.
Stock prices change only when there is a shift in the underlying demand and supply curves. The most likely cause is a change in expectations. Remember that stocks are ownership shares. Because they give you a share of future profits, their value depends upon the how much future profit the firm is expected to earn. An increase in expected future profits of a firm will drive the demand and price of its stock up; a decrease in expected future profits will drive the stock price down.
Imagine Merck announcing progress on the development of a new anti-obesity drug or Nike introducing a shoe that enables an athlete to jump 30 percent higher. Each of these would change the expected value of the firm, increase the demand for its stock, and drive up the equilibrium price. Similarly, a new scientific study showing that Merck's current best-selling drug product causes dangerous side effects or the discovery that Nike shoes cause foot fungus would quickly send the demands and prices for their respective stocks into a downward spiral.
Can you beat the market?
Over the long haul, stock prices tend to rise. On average, investors earn very respectable rates of return. Some will buy the right stocks at the right time and earn even more; they will beat the market. But not all stock prices rise, and not all investors make profits. For every investor who beats the market and earns above-average returns, others walk away with losses or below-average returns.
The trick is to know what direction prices will move; to buy before prices rise and to sell before prices drop, to buy low and sell high. Buying shares at $10 and reselling at $30 will fatten financial fortunes quickly. If only it could be you. If only you could predict which way prices will be moving. If only you could know when to buy and when to sell. If only pigs could fly.
It's fantasy. It's a pipe dream. We can observe how prices have changed in the past, but past values are poor indicators of future values. Despite the claims of fast-buck scam artists, there is no statistical way to predict future stock prices on the basis of historic patterns. There is no scientific pattern of buying and selling that will enable someone consistently to beat the market. Think it through. If someone discovered a sure-fire method to beating the stock market, would they not already be rich? If they already can make unlimited sums playing the market, why are they hustling to sell us their system?
Remember that stock prices are driven by expectations. Work through an example. Suppose that Exxon stock currently sells for $100 a share. Suppose next that Exxon implements a new refining technology that will boost future profits by 30%. What should happen? If profits rise by 30%, a share of stock should be 30% more valuable. That $100 share price should rise to $130.1
Wait. Suppose that professional market analysts already knew that Exxon was working to develop this new refining technique. Suppose they expected this to happen. If they expected this to happen, they should already have been buying up Exxon stock in anticipation. And, if they already were buying up Exxon stock, that already should have been driving the stock price up. Think about it. If the current price was $100 and you expected it to rise to $130, what would you do? You would buy. But this increases the demand for the stock and drives up the price. If the price rises to $110, what will you do? You would keep buying. As long as the price is below $130 it's still a good deal. You should keep buying until the price goes all the way to $130. At that point, it's no longer a good deal and the process stops.
Do you see what's happening? If financial analysts predict that future profits are going to rise, they quickly will drive up the demand for the stock. If they expect the future stock value to be $130, they will bid the price up to that $130. In other words, the current price of a stock should always reflect the expected profits of the firm.
Do you want to beat the market? There only are three ways to do it.
1. Outsmart the professionals.
If the best guess of market analysts is that expected profits warrant a $130 stock price, they will push the price to that $130. But suppose you are smarter than the professionals. Suppose you predict that future profits will exceed the market estimates and that the stock price will go to $150. In this case you should buy at $130, wait for the higher profits to emerge, wait for the market price to rise to $150, and sell at a profit. Can you do it? Can you outsmart the professional analysts? Probably not. Even the professionals cannot do it. Some do beat the market for years at a time, but no more than we would expect from random chance.
2. Break the law.
Perhaps your uncle works for Exxon and passes along inside information that analysts do not know. Perhaps he tells you about the secret new refining technology Exxon is ready to unveil. You’ll have an edge. Your inside information might enable you to predict future profits more accurately than can outsiders. There’s just one small problem. Trading on inside information is illegal. It’s why Martha Stewart spent a year in jail. Of course, you might not be caught…..
3. Get lucky.
Suppose someone offers you the following deal: flip a coin twenty times with a payoff of $1 for each head and negative $1 for each tail. On average you’ll flip similar amounts of heads and tails and break even. But suppose you’re just plain lucky. Suppose you take the deal and flip 20 heads in row. You’ll walk away with a new $20. Of course your profit did not result from some superior ability to flip heads, it resulted from luck. Could you do the same with stocks?
Safety first
As for me, I cannot outsmart the professionals, I am unwilling to risk breaking the law, and my gambling luck is average at best. I cannot beat the market. I stopped trying years ago. Instead I am content to match the market. I invest in mutual funds that own a broadly diversified set of corporate stocks. Some stocks in the mutual fund’s portfolio perform better than average, others worse than average. I may never make a financial killing with such a fund, but I minimize the chance of a financial bath. Over the long haul, my fund profits will match the market.2
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Notes:
1. Readers with financial expertise might see that this is strictly true only if interest rates equal zero. Otherwise we should look at discounted present values of expected future profits.
2. Economists report a variety of stock market indexes that track price changes for groups of stocks. The Dow Jones Industrial Average is the most widely reported and tracks what is happening to stock prices for a sample of 30 major corporations. Professionals often pay more attention to broader indexes such as the S&P 500 (it tracks 500 major stocks) and the NASDAQ (it tracks all stocks traded over the NASDAQ exchange). Many investors choose to buy Index Funds that contain all of the stocks tracked by an index. For example, an S&P 500 Index Fund would contain representative shares of all firms included in the S&P Index. As a result, if S&P 500 Index were to rise by 14%, the value of the index fund would increase by the same 14%. It will match the market exactly.
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Testing Yourself
To test your understanding of the concepts in this reading, try answering the following:
1. What is a stock?
2. Explain why current stock prices respond to expected future profits.
3. Identify and explain the three possible ways an investor might beat the market and earn higher than average returns.