Master Two Levels of Supply and Demand

 | Dec 19, 2013 | 3:43 PM EST
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I've always been adamant that you don't need a degree in economics to invest wisely. All you need is the ability to think critically and make judgments about companies you find compelling, after looking at the annual report, reading the conference calls and understanding where that company fits into the economic firmament. Does it do better when the economy's humming? Does the strength or weakness in the economy mean little to the enterprise's earnings? Do earnings go higher if the Fed keeps interest rates down to spur the economy? Will it get hammered if the Fed says the wrong thing?

But there's one part of the economics lexicon that does matter to stocks, and that's the law of supply in demand. As someone who took a ton of economics classes, this concept got pretty much tattooed to my brain. However, I find that many people don't understand it. So I am going to explain in a simple way how the law of supply and demand affects stock prices and earnings, because it is driving a lot of the price movements that have been mystifying people of late.

First, there's the law's application to the stocks themselves, not the entities they represent but the actual equity that trades.

Let's contrast two equities, Twitter (TWTR) and Citigroup (C).

Twitter is rallying, because there's not only more demand for its stock than there is supply, there is also more demand for stocks in its sector than there are stocks. It seems as if no one who bought Twitter on the deal is interested in selling it now, because they believe that this company is going to come up with a gazillion ways to make money with advertisers. Perhaps more important, the market perceives that there are only a handful of companies that have mastered social mobile and the cloud, and Twitter is one of them and Facebook (FB) is pretty much the other. Consider that Facebook is creating 27 million shares, and the CEO and founder Mark Zuckerberg is selling 41 million shares. Normally, that would club a stock down 5%. The darned thing is barely down. Demand is overwhelming supply.

Now consider Citigroup. It's one of hundreds of banks, all of which are pretty much trading together. We don't need more bank equities. Second, there are 3 billion shares outstanding, and no near-term hope of that number shrinking, as the regulators seemed determined to force Citigroup to have as much capital as possible on hand. It's a supply-demand nightmare.

The second kind of supply and demand that people don't seem to get, though, is when there is tightness of a particular product until more plants come on line to create price equilibrium.

Take DRAMs, the most basic form of memory chip. Micron (MU) is one of the biggest makers of DRAMs in the world. The DRAM market has been oversupplied for years and years, but recently companies that manufacture them have been faltering, and there's been no new capacity added in some time. That has allowed DRAMs, which have been perennially falling in value, to stabilize and even increase in average selling price.

This week, Micron took a real header. Why? Because its competitor Hynix is rumored to be building a new DRAM factory. Just the rumor sent the stock down, because a competitor's new factory could put the DRAM market into equilibrium or, worse, oversupply, and prices would plummet. That was all it took.

Similarly, Seagate (STX) and Western Digital (WDC), two big disk-drive manufacturers, have benefited from a surfeit of new drive factories, as neither they nor anyone else saw much of a need for new ones, given the decline in PC sales and the ascendance of flash memory. But get this, just the idea that a DRAM factory might be built sent these stocks lower, for fear that it might lead to new disk-drive capacity.

Yep, you don't need to be an econ major to understand stocks, but if you don't understand supply and demand, and you don't recognize how it can affect the pricing of the stocks you own, then you will be mystified about stock price movements, and a mystified investor is a bad investor. Know your metric. If something is in tight supply, it could go higher, and if there's a ton of it, you can bet it's going lower. 

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