Tuesday, September 30, 2008

When Buyers Meet Sellers

Jim Parker, Regional Director, DFA Australia Limited

"Sellers were out in force on the market today after negative news on the economy." So say the talking heads on television each night. But have you ever wondered if there are so many sellers out there, who is buying?

The notion that in bear markets sellers outnumber buyers just doesn't make sense. What the newscasters should say, of course, is that there were not enough people willing to buy shares at the prices the sellers were seeking.

What happens in such a case is either the would-be sellers sit on their shares or prices adjust lower until supply and demand come into balance. This is when transactions occur and is described by economists as "equilibrium".

But equilibrium isn't a permanent state. That's because new information continually is coming into the marketplace, forcing would-be sellers and would-be buyers to constantly adjust their expectations.

That new information might be company-specific news like an earnings warning. It might be news that has implications for an entire industry—like a spike in oil prices forcing airline stocks lower. Or it might be an economic development that affects the entire market, like a change in interest rates.

Given this constant flux in news and information flows and the forever changing expectations of participants, individual securities and the market itself are said to be always moving toward equilibrium.

When markets are going down, it can be reassuring to remember that at some point supply and demand must come into balance. Buyers eventually will see value in the market and will invest if the prices are low enough.

Trying to time these inflexion points is a fool's game, by the way. That's because prices tend move in a random way. So it is next to impossible to predict with any consistency what the market will do next.

This in turn reflects the difficulty of successfully forecasting the future. That doesn't stop many people from trying, mind you. And sometimes they get it right. But that's usually down to good guesswork, not scientific method.

But during times like these, investors can comfort themselves in the knowledge that in a market economy, over the long term, there is a return on capital. If there wasn't, capitalism would no longer work.

They should also recall that when companies' share prices are low relative to their fundamental values, their cost of capital is going up. In other words, investors are being offered a higher expected return.

So rest assured, there are still plenty of buyers out there. The market is doing its job and the rewards will be there if you remain disciplined and diversified.