What Moves the Market

In the midst of an epic bear market, it is easy to succumb to irrational thoughts. To keep things in perspective, it helps to understand how stock prices are determined.

A stock price represents an equilibrium between supply and demand. When demand for a stock outstrips the supply, its price will rise until equilibrium is reestablished at a higher price. Similarly, when supply exceeds demand, the price will drop. The supply and demand for shares of stock are provided by sellers and buyers, respectively.

What induces a seller to sell and a buyer to buy? For an individual, it could be almost anything. Some investors base their buy and sell decisions on sophisticated valuation methods. Others have been known to buy or sell depending on the phase of the moon. In other words, individual buy and sell decisions range from rational to completely irrational.

An interesting phenomenon emerges when the market is considered as a whole. The net weighting of buy vs. sell orders for a given stock determines whether its price moves up or down. In general, the irrational buy orders seem to cancel out the irrational sell orders. The net result is a surprisingly rational mechanism for determining stock prices. In fact, the pricing mechanism is so efficient that even the sharpest market professionals have difficulty determining whether a given stock is overpriced or underpriced.

There is one more factor to consider in discussing what moves the market, and that is information. As new information becomes available, people respond to it in different ways. The market's response to new information is the summation of each individual's response. Some data, like quarterly earnings reports, relate directly to a specific company. Other information, such as a change in weather patterns, is indirectly related to the stock market. Any news that might affect a company's economic well-being can influence its stock price.

When will the current bear market end? Nobody can answer that question because it depends on future information, which is unknowable. However, there is some comfort to be gained from the basic rationality of the market pricing mechanism. Corporate profits are holding up reasonably well. Productivity, a key to economic well-being, has held strong. Overall economic growth, while slowing, is still around 3 percent. But with each day bringing a new revelation of corporate malfeasance, the bad news has overwhelmed the good. The bear market will end when the market finds more good news to respond to than bad.

August 1, 2002

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