Anyone who is an investor, or a just keen observer, or a stock market analyst knows that stock prices fluctuate from time to time, for good and sometimes not so good reasons creating temporary moments of “highs” and “lows”. For many, especially stock analysts and active investors, these fluctuations can potentially be very stressful. The fundamental aspect to this, however, remains true, in that the success in the stock market investment requires patience and a willingness to see past fluctuations to study the bigger picture over a horizon. With time, you gain the experience to better interpret price fluctuations; with time, history tells, stocks always have the upward trajectory. So, a rational investor should be able to understand and appreciate this truth.
However, as it is with human nature, rational investors are not many out there, that’s why lows and downs moments are highly highlighted to the extent of, in some cases, eliminating altogether the memories related to good moments when we enjoyed the highs and ups. I have just mentioned “human nature”, and to bring my point even closer to our “human nature” – one might say, the stock market can quite tell a story closer to a love story, somehow complete with break-ups (and make-ups). And as it is with such relationships, split-up doesn’t always mean a relationship is dead, sometimes an “end” could just be a set up for a new beginning, with reconciliations and re-corrections. And therefore, much as we have seen the downward trend for certain moments, there will be a period of reconciliation and re-correction – but is it always the case? The answer to this we have to consider the fundamentals of investments and stock markets theories. Theories that have been tested by history and proven, in most cases, to be meaningful for referencing. Referencing to our piece today, I would like to refer into the “Dow Theory”.
Charles Dow, the founder of the Wall Street Journal and inventor of the world’s first stock market index, was the first financial analyst to scrutinize stock market fluctuations and interpret its bigger picture. He studied the ups and downs of the market and developed the so-called “Dow Theory” which, among other things, defines a “trend.” All stocks move up and down over time, creating temporary “highs” and “lows.” When a stock creates a sequence of “higher highs and higher lows,” it is trending. This suggests that the motivations of market participants are in favor of price moves in one direction, either up or down. Either the trend is up, and demand for stock is high, or the trend is down, and more investors wish to sell stock than buy it. And, so – this boil down into the fundamental matters of demand and supply as well as investors’ sentiments, which then determine the efficiency in how stock prices are determined and in which the market behaves.
So, how does this work? Let us start with the supply side — for any stock, most times there are a set number of shares outstanding. When you want to purchase shares, you must compete with other buyers for the limited supply available in the market. Where does this supply come from? Shares are only available to buyers if their current owners choose to sell them. Thus, supply in the stock market consists of stock being sold. If few or no traders want to sell their stock, then there is no supply and buyers can have difficulty opening positions.
Demand — when you want to sell shares, they can only be liquidated if someone else wants to purchase those shares from you. Thus, your supply must be met by demand in the marketplace. In the stock market, demand equates to buyer interest. If no one is interested in buying the stock you wish to sell, then you may have difficulty getting rid of it. In such a case, sellers are competing for the few buyers that are present.
The goal of any stock market is to facilitate the trade of securities. Stock market ups and downs are directly caused by an imbalance in supply and demand emanating from both fundamental and sentimental based factors. Prices remain consistent or “flat” if supply and demand are approximately equal. If there is more supply than demand, then sellers must accept lower and lower prices as they compete for buyers’ interest, and the stock drops in price. Likewise, when a stock is in high demand, buyers must pay higher and higher prices to compete for the few shares available, and the stock increase in price.
As indicated, demand and supply (which are determinant of stock prices) have fundamental and sentimental origins. Sentiments! yes — the relationship between supply and demand in the stock market is often called “sentiment.” When stocks are in high demand and prices are rising, the sentiment is mostly positive which leads to fewer stock owners wishing to sell and more investors wishing to buy. Extremes in sentiment ironically precipitate major market fluctuations. When sentiment reaches a positive extreme, a stock market drop is often imminent. “Contrarian” investors, the like of Warren Buffet, monitor market sentiment and trade opposite the prevailing attitude. The cause for this is simple. When most participants in the market have a similar opinion, there is more room for some of them to change their minds. When sentiments are more balanced, there is more room for skeptical investors to eventually join the prevailing attitudes and start a trend. Strong opinions in the masses rarely last for long, as more balanced sentiment is healthy. To conclude, despite the up and down swings of the stock market, to maximize your investment returns, apply some pro-active investment management philosophy. This is imperative –particularly in stock selection that is informed by a view on the market cycles, company returns and diversification as you try to ignore the rumors you hear about how stocks are valued or the stock market behaviors. Try to resist the naysayers and their model-driven predictions about how the market can go, in most cases their forecasts have proven to be not more valuable than a coin toss. In all these, it is good to try and maintain your cool head and handle well your emotions. Yes, there are seasons that are not so good, but if only you have the patience, the growth trajectory is always there.