The Dual Role Of Price In Financial Markets

by: Dorsey Wright Money Management

By Mike Moody

Price has a dual role in financial markets.

  • Price represents the intersection of supply and demand. It is the point at which buyers and sellers can agree on a value at which to exchange. Everyone in the financial markets knows this. Even economists get it.
  • Price also stimulates demand. This price function is largely overlooked in the financial markets, but is the very reason why investors pile into strong stocks or strong assets. Relative strength can obviously be a great help in identifying what those strong assets are. Economists don’t understand how higher prices can drive demand, and just think investors are irrational.

If you are not convinced, here’s an excerpt from a Bloomberg article today:

Hedge funds trailing the Standard & Poor’s 500 (SPX) Index for the last five months are giving up on bearish bets and buying stocks at the fastest rate in two years.

The reason is obvious, and also mentioned in the article:

The benchmark gauge for U.S. equities is on track for the best first-quarter gain since 1998, according to data compiled by Bloomberg.

Yep. A strong market stimulates demand for equities. This tends to be true of all financial markets.

This runs counter to the traditional economic theory of supply and demand, where lower prices are expected to stimulate demand. Traditional economic theory is correct in a special case—only if there is a concrete end use for the product. For example, if gasoline prices went to $1.25 per gallon, users might be tempted to put tanks in their driveway and fill them up to take advantage of the low price, knowing they will use the gasoline later. The same thing will be true of canned goods, toothpaste, and toilet paper. People will buy as much as they can use before it spoils to take advantage of low prices.

Stocks are different. Financial assets are intangible. You can’t eat stock certificates or fuel your car with them. Their end use is performance. Performance is intangible, but performance depends on rising prices (assuming you are long, anyway). When prices are rising strongly, it is a market signal that this asset may be useful for performance—and that is what stimulates additional demand. Relative strength is like a neon sign in this respect.

Hedge funds and institutional investors are particularly subject to performance pressures, so they are very sensitive to market signals. When markets are trending, they tend to go after the strongest assets first. This is entirely rational economic behavior when continued poor performance can put you out of business. Money flows follow performance.


[Endnote: It is entirely possible, of course, to buy stocks when they are out of favor and make money too. This is exactly what contrarian, value investors do. One of the appeals of value investing is that buyers have very little competition when buying out-of-favor assets. Yet even a value investor needs demand fueled by rising prices to ultimately profit. It may be true that for every asset there is some "fair" or "intrinsic" value, but it's probably also true that the asset is correctly priced only twice each cycle---once on the way up, and once on the way down.]