Is The Price Right? Understanding Pricing and Market Swings
It is often said that stock prices take the stairs up and the elevator down. In the first half of 2020, we saw how fast that elevator ride down could be. In just two months, U.S. stocks lost effectively years of gains. In fact, this was the fastest decline of 30% or more that we’ve ever experienced. U.S. stocks weren’t alone on the elevator ride down. Joining them were stocks of all developed and emerging countries, as well as many commodities, like oil. True, oil’s decline was exacerbated by a debate between Russia and Saudi Arabia over the amount being produced, but no one expected it to briefly trade at a negative $37 per barrel.
WHY PRICES SOMETIMES FALL FAST
Given these wild swings, can we trust market prices? Further, was it “right” for prices to fall this fast, and then subsequently start to rise while economic data continued to get worse?
To answer these somewhat related questions, we need to think about how market prices are determined. Like with many items, supply and demand help set the price for stocks, bonds and commodities. If a lot of people want to buy something, the price usually goes up.
And, if a lot of people want to sell something, the price usually goes down. This is exactly what happened during the declines we saw earlier this year. Some investors started to get nervous about the impact of the coronavirus on the global economy and their investments, and they sold stocks. Prices typically fall faster than they rise because investors fear loss.
This fear of loss typically causes additional selling pressure. Imagine, for example, that a group of investors plans to sell when their losses reach 10%, or who maybe just can’t stomach a drop of this size. When a 10% market decline occurs, that group of investors start to place their sell orders. All those new shares for sale increase the supply of stock available, so prices head even lower. Then imagine there is another group that plans to sell at a 15% decline, and another group that plans to sell at a 20% decline, and so on. Once each of these thresholds are hit, the supply of sell orders goes up and prices continue to go down. Ironically, an investor’s plan to avoid losses could cause markets to fall further.
To stop the declines, there needs to be a change in what is happening so that investors near their “get-out-of-the-market” point decide not to sell, or that a new group of investors might find the lower prices attractive and start to buy. Investors who end up waiting to sell help relieve the supply of shares for sale, and the new investors increase the demand for shares to buy. The buyers outweigh the sellers, and market prices start to rise.
WHAT IS THE RIGHT PRICE?
While this example may seem overly simplified, it is essentially what is happening in the markets every day, regardless of whether a global pandemic exists or not. Buyers and sellers are constantly negotiating for what is essentially the right price to trade with each other. New information is what causes people to want to buy or sell. If the news is poor, expect markets to decline. If the news is positive, expect them to rise.
We think it makes perfect sense that stock and commodity prices fell when they did and as fast as they did. Because prices rapidly reflect new information, news that millions of people were not going into the office, that businesses were shuttering, that millions of lives were in peril, and that life as we knew it was sure to change for the foreseeable future will certainly make some investors want to sell.
The good news is that these are the attributes of a highly efficient marketplace. When new information is introduced, prices adjust. This is exactly what we want to see happen, and we should be concerned if it didn’t. While we may not like the direction and speed of some price adjustments, they ultimately represent a price where a buyer and a seller are comfortable exchanging a share of stock, an amount of a commodity, or a bond certificate for cash. In our mind, that seems like the right way to determine a price.