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Every year, the Christmas shopping season provides us with a wonderful lesson on the economic law of supply and demand. It begins on the day after Thanksgiving, with merchants offering huge discounts (on just a few items) in order to lure you into their stores in hopes of jump starting your shopping spree. For us procrastinators, the day or two before Christmas we are scurrying through the stores paying any price just to finish our shopping before the big day. It ends the week after Christmas, as the bargain hunters look to help their local merchants clear their shelves of all the items they overstocked (and didn’t sell the previous month).

The law of supply and demand is capitalism’s method of determining prices. When the demand is high and goods are limited, the prices head higher. When demand is low and goods are plentiful, prices decline. This basic law works on common stocks just as it does on the merchandise offered in your local retail stores. This pricing method is so important to the daily setting of stock prices that even the great value investor Seth Klarman gives homage to it in the first chapter of his book, “Margin of Safety”, with these words:

In the short run supply and demand alone determine market prices. If there are many large sellers and few buyers, prices fall, sometimes beyond reason. Supply-and-demand imbalances can result from year-end tax selling, an institutional stampede out of a stock that just reported disappointing earnings, or an unpleasant rumor. Most day-to-day market price fluctuations result from supply-and-demand variations rather than from fundamental developments.

Supply and demand is the basis for technical analysis, the heartbeat of momentum investing, and for just about every other short-term trading method deployed by an army of speculators world-wide. The past year’s volatility of market prices is pretty good evidence on how quickly demand for shares can change. When the call of the day is “risk on” the market rises. When the call of the day is “risk off”, the market falls.

The rapid change in price also tells us that in the short-term, the supply of shares is fixed. In the long term, the supply of shares will dominate market pricing. Unlike the demand for shares, which can change instantly, supply of shares changes slowly. The supply increases by the amount of new capital that is raised through Initial Public Offerings (IPOs). The supply decreases by the amount of existing capital removed from the public markets through share buybacks.

The last few years the supply of shares has changed. These changes are setting the stage for long-term positive returns in the public markets. S&P Indices keep tabs on the amount of stock buybacks completed by the S&P 500 companies quarter-by-quarter. Jay R. Ritter, Cordell Professor of Finance at the University of Florida has been keeping track of Initial Public Offerings for years. Take a look at buybacks side by side with IPOs for the past three years:

*Buybacks $ Billions

**Aggregate Proceeds of IPOs

2009

$137.65

$13.17

2010

$298.82

$30.69

2011

$437.49

$26.97

Total

$873.96

$70.83

*S&P 500 companies only ** Includes only U.S operating companies whose offer price exceeds $5.00 per share.

Last week, when S&P announced the preliminary results for 2011 shown above, Howard Silverblatt, Senior Index Analyst at S&P Indices, stated,

We need to start paying attention again to the growth variance in net income and EPS. The trend is growing in share count reductions, which brings increased earnings per share with it.

Of course, an unexpected increase in earnings could easily improve demand.

As our law of supply and demand states: When demand increases and the supply decreases, the price will increase. We can clearly see that the supply of shares has decreased with a high probability of improving demand. An intelligent investor would use this to his or her advantage and buy shares today. S&P in their release listed the twenty companies in the S&P 500 who repurchased the largest dollar amount of their shares in the third quarter. A few of my favorites, all of which I own personally and included in the top 20 of companies are American Express (NYSE:AXP), Walt Disney (NYSE:DIS) and PepsiCo (NYSE:PEP). For smaller accounts the SPDR S&P 500 (NYSEARCA:SPY) would do just fine.

Source: Supply And Demand: What IPOs And Buybacks Are Telling Intelligent Investors