There’s a common belief that assets rise when there are more buyers than sellers. The truth is more subtle. Every time a stock (or any other asset) trades, there’s both a buyer and a seller; whenever the market is functioning there must always be an equal number of buyers and sellers. So what makes stocks move in a particular direction? The simple answer from economics is that there were more buyers than sellers at the old price, so the stock price must rise to entice new sellers into the market and dissuade the buyers. This is frequently true, but is far from the whole story. There are many momentum traders who are more likely to buy a stock as it rallies.
As the stock market rallies, the general public becomes more optimistic. More investors believe that stocks are great long-term investments and they allocate a greater portion of their savings to stocks. During big sell offs, many investors swear off stocks forever and even sophisticated investors reduce their exposure. Investors with a historical perspective describe this as the fear-greed cycle. Over periods of 5+ years, investors act exactly opposite the “rational” way economists expect. As valuations climb to the sky there are ever more buyers.
If buying causes more buying, what breaks the cycle? Every asset bubble forms a pyramid. Eventually you reach the top where everyone who might possibly participate in the bubble has already bought in, and there’s no one left to buy. In real estate, this happened when everyone who could possibly be enticed to buy a second home did, and when every bank that would greedily chase the 0-down loans had. Eventually there are no more suckers and the pyramid collapses. A pyramid that was gradually built over a decade can collapse in 6 months. Once you reach the point of no new buyers, the first hint of selling sparks a panic. All the overleveraged speculators were buying because prices seemed like they could only go up; as soon as prices start coming down they all run for the exits.
So how should we think of a rally? Are stocks rising because there are more buyers regardless of price, or are there just more buyers at this price. I think the approach that is most accurate most of the time is this: at any given time there are a lot of players with prices in mind who provide liquidity to the indiscriminate investors. There are price-sensitive investors who think Microsoft is worth $25 and are looking to buy for $20 and sell at $30. There are the price-insensitive passive investors (the vast majority of all investors) who just allocate a portion of their savings to stocks via a 401k, IRA, or pension plan. Finally, there are the price-insensitive active investors who watch CNBC and buy whatever company seems hot without much regard to valuation, or avoid buying stocks when things seem gloomy. When the price-insensitive investors become optimistic and start buying, they drive the prices of most stocks up. Prices stop rising when the optimism fades. The price-sensitive investors drive prices at the margin (causing better companies to outperform over time) or when the price-insensitive investors aren’t pushing things around too much.
Originally published at Risk Over Reward blog and reproduced here with the author’s permission.