While stocks may seem to act very differently from physical goods, the price of tomatoes and public shares are subject to the same basic laws of supply and demand. In fact, identifying supply and demand dynamics in the stock market can be easier than doing the same for most other goods. An extremely detailed price history of all trading in a stock is publicly available, while this is rarely true for tomatoes or apples.
Technical analysts often refer to the strength or weakness of a particular stock or the stock market in general. Strength indicates dominance of demand, while weakness means supply is stronger. A strong stock will climb more often than it falls, as plenty of buyers are waiting on the sidelines to buy the stock if it retreats even slightly. A weak stock will advance briefly before sellers supply stock to get rid of their holdings and drive prices down. Therefore, the general direction of prices, assessed by a trend line on a price chart, is the most important sign of supply and demand imbalance.
The trading volume, which is simply the number of shares that change hands on a particular day, is another indicator of supply and demand inequality. A simple test is to compare the trading volume on days when the stock price climbs to the trading volume on days when the stock price declines. If demand is stronger, up days should see higher volume, while stronger supply would manifest itself in the form of high volume on down days. In general, any movement with heavy volume is considered to have lasting power, while up or down moves accompanied by low trading volume tend to be transient.
Mutual Fund Flows
Mutual funds accumulate a significant quantity of shares, thereby contributing to general demand for stocks. Therefore, the amount of money available to these institutions can be a strong indicator of demand. Since mutual funds collect cash from individuals, the amount of cash that the general public invests in mutual funds will soon find its way into the stock market. Analysts track not only how much cash individuals have recently sent to their mutual fund companies but also what percentage of this money the mutual fund companies has invested in stocks versus the percentage that is yet to be invested, as fund managers try to spot good stocks to buy.
Initial Public Offerings
The supply in the stock market has two sources. Investors who are holding and desire to sell shares, as well as corporations that wish to issue new shares both contribute to demand. Issuance of stock and its sale to investors by corporations is referred to as an initial public offering. Once this initial sale occurs, the stock then changes hands among investors. Closely tracking the number of shares that corporations will sell over the coming months in IPOs provides a good idea about the level of demand over the foreseeable future. Especially when IPOs far exceed mutual fund flows, demand is said to be dominant.
- Medioimages/Photodisc/Photodisc/Getty Images