Sunday, March 1, 2009

Sunday Reflection: Supply and Demand Curves to Describe Equity Prices

Basic economics can be used to describe the investment landscape and are easy to explain if you consider investment vehicles as different products and different asset classes as substitutes for each other. Again, just like any fungible item which can be bought and sold, stocks are bound by the laws of supply and demand.
Savers (with net positive capital) represent the demand curve for investment vehicles, while companies issuing various investment vehicles (net negative capital) represent the supply curve of investment opportunity.

The float or the number of outstanding stocks actively traded at any given time, would be described as quantity supplied / demanded where the supply and demand curves meet. Note that unless there are additional shares issued (or a company stock buy back) the supply curve is relatively inelastic.

Trading volume and price would be represented by incremental movement of the qs / qd equilibrium (notice that for every transaction, there is a buyer and seller of the same product so the qs /qd immediately returns to its equilibrium point) and it's associated price movement.

Substitute products for equity class assets include fixed income instruments such as bonds, mezzanine instruments such as preferred shares or others investment vehicles.

IPO's or secondary offerings would be represented by a right shift in the aggregate supply curve (more supply and options for investment vehicles)

Companies going bankrupt would be a left shift in the aggregate supply curve (less supply).

The aggregate demand curve (and movement in it) would most likely be caused by growth in the wealth of the general population (more wealth means, more saving and more demand for investment vehicles) manifesting as more people putting money into the market.

Finally, "financial innovation" usually describes a method of artificially boosting the one of the market's economic curves. Previous examples include: RRSP or 401k qualified purchases of stocks (demand right shift - releasing more cash into the market), and the more recent (and disastrous) recursive packaging of various CDO trenches (supply right shift - providing additional places to put your money to maintain growth).

Now that we have all the pieces, how can we use this to describe the current economic crisis?

While the market was super hot, bankers had to look increasingly harder for new investment vehicles which could potentially give the same return. This has lead to the poor lending practices we so often hear about where banks were loose with their money in the housing market. These housing loans were collateralized to redistribute the risk and parceled out to investors.

When these bad loans started to default, people started to panic as they realized that what they had bought wasn't investment grade (as they had be lead to believe) but really just junk.

Then people start to liquidate their positions and the demand curve for that asset class takes a huge shift to the left dropping prices in equities across the board. It is very hard for the companies to match this movement (as a left shift in supply means they are rapidly becoming smaller) and supply is relatively inelastic in this scenario. Unless the company is delisted or otherwise has its stock forced off the market, there remains an oversaturation with the number of stock issues.

However, all this capital flowing out has to go somewhere. This is the "flight to quality" that everyone hears about, where people take their money out of risky asset classes (such as equity) and start dumping them into more stable US government T-bills or bonds (or stocks in defensive companies). This causes a huge right shift in the demand curve of that asset class and the prices skyrocket.

As an Engineering student, I've always believed that "You can cheat on your exams, but you can't cheat physics" as a good lesson and warning for those who would try less scrupulous methods to succeed. However, even in investing where the science is greyer and mixed with equal parts art, it's both reassuring and telling that the laws of gravity and science of economics still hold.

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