What makes stocks rally?

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.

9 Responses to "What makes stocks rally?"

  1. Guest   April 8, 2009 at 12:24 pm

    The ‘driver’ in today’s stock market environment is entirely due to hedge fund and career traders who feed off each others’ actions; when they see bids offered, they act in concert which drives prices -and- vice versa.Most individual investors have not returned to equity investing.

  2. awakened   April 8, 2009 at 2:37 pm

    Anonymous dark pools of liquidity via upstairs trades which reflect no volume are the drivers. Uptick rule or not, what enlightened investor would want to invest in this scenario?

  3. NFrazier   April 8, 2009 at 6:53 pm

    Closing down firms that are insolvent or attempting to paper over the fact that some other firms are or will be insolvent. The heuristics of rallies may change in the future however.

  4. Guest   April 8, 2009 at 8:17 pm

    Difficult to beleive in the sanctified trinity, supply demand, prices since a long decade.Financial markets are nationalised and this explains why more nationalisation are overdue.

  5. Anonymous   April 8, 2009 at 10:50 pm

    Thanks for sharing your observations.

  6. George Harter   April 8, 2009 at 11:52 pm

    Another factor is simply desperation. The average Jane/Joe has been told very firmly, this market is a great value!! BUY< BUY< BUY!! Desperation for a return of the “GREAT” days of the early 2000’s.If you’ve lost 33% of your 401K, try and win it back in the market REBOUND! (Also help the pros unload some more of their trash, these bubbles ARE functional for SOME people) Fundamentals are distracting. In fact paranoia could drive some to believe that the bad news is a trick to keep one out of a hot NEW BULL MARKET(who knows??).I only wish I knew how to guess what day (or week) this DEAD CAT will rot and burst. Getting cynical, I am looking forward to hearing all the gnashing of teeth and then seeing the FINANCE crowd turn on all these suckers and say “I told you so!!” that is, after they have been recommending the opposite for months (who keeps track anymore??)George HarterBaghdadontheHudson, USA

  7. Guest   April 10, 2009 at 6:54 am

    Vega, that’s not quite how it works. The posting is full of errors, but let’s just focus on one: “Whenever the market is functioning there must always be an equal number of buyers and sellers.” I’ll use proof by counterexample to demonstrate the inaccuracy. Let’s say I’m a big mutual fund that wants to move a block of 100,000 shares without a large negative price impact. The NYSE trading systems that cater to large institutional investors will work my shares into the general flow of trading volume in smaller units to minimize the price decline from an increase in the supply of shares offered for sale. The 100,000 shares could be bought by 20, 30, or more smaller players. In this case markets are functioning well, but there’s an unequal number of buyers and sellers. What you meant to say was “When markets are functioning well the quantity of shares buyers are demanding should approximately equal the quantity of shares sellers desire to sell.” The number of buyers and sellers are irrelevant, it’s the quantity of shares that matters.

    • Guest   April 10, 2009 at 7:46 am

      “The number of buyers and sellers are irrelevant, it’s the quantity of shares that matters”. Duh! That’s kinda obvious isn’t it? I don’t think the original author was trying to say that for each individual seller, there is exactly one buyer. The idea is that for each unit being sold, there is someone interested in buying it.

  8. Deen   April 13, 2009 at 8:13 am

    Hi,I was just wondering how big are in proportion of these “price insensitive active investors” relative to the market?