Behavioral Finance

Demand? No Such Thing.

Equity prices are ultimately determined by basic supply and demand.

Equity prices are ultimately determined by basic supply and demand. It's that simple. We learn it in Econ 101. The complicated part is trying to figure those two factors out.

We can reasonably measure supply. That's a tangible thing. Holding demand constant, if the supply of stocks goes down, then stock prices must go up. The reverse is also true—if new stock supply is brought to market then prices should drop (again holding demand constant). Very basic stuff.

Demand is the tricky one. Measuring market demand for stocks is a desperately slippery enterprise. There have been countless tries at measuring it and all of them ultimately fail. Valuation models, economic fundamentals, sentiment models…none of them work all the time and most don't work at all.

Why can't we just empirically measure demand for stocks in the same way as supply? It's because there's no such thing as demand—it doesn't exist but in the collective psyche of humans. Without humans, in nature there is no market per se, there isn't even an economy! These are things of our cerebral creation.

This means understanding markets is ultimately a function of psychology. That's why capitalism is so potent. Capitalism doesn't rail against our natural tendencies, it's aligned with the way our brains work. Capitalism is the closest thing to nature we've got for a system of resource allocation. Our brains were wired long ago for an environment that featured survival versus predators in the wild and competition for scarce resources…sounds a bit like basic demand, doesn't it? That's precisely what the system of capitalism captures.

Every single day the financial press will try to give you a "reason" the market was up or down. What an absurdity! With millions of participants all over the world and the incredible variation in sentiment and psychology, simple explanations simply fail. Demand isn't so tidy.

When we think about how markets work, and specifically demand, we must think in terms of psychology as well as empirics. In the end our Stone Age brains are the ones that created it in the first place.

Have a great weekend.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.