Even in a pre-covid-19 world, my brother would always ask me why the market (and more relevantly) individual stocks would often defecate themselves. He did not say ‘defecate’. ‘Defecate’ is very much a euphemism here. Everyone’s talking about large dips or rallies in the market these days but if you distance yourself from the market more broadly and look at individual companies, you’ll notice this happens on a smaller scale all the time (covid or otherwise). So let’s take a look at what you might typically expect to impact asset prices – what makes things go up and down.
Demand and supply
Demand and supply govern everything. Whether something is expensive depends on how much demand there is for that something and how easily that something can be supplied – this logic extends to assets as well. When you see share prices spike, it’s because there’s renewed demand in the market. When you see house prices spike, it’s because more buyers are in the market trying to outbid each other for the same property. See Economics 101 for a longer discussion on demand and supply.
But why is there demand (or lack thereof)
Ah yes, now you’re asking the important questions. And by you I mean me – I’m writing the article after all. But so long as you’re thinking about these sorts of questions, you’re on the right track. Let’s look at demand first. Why should there be a sudden spike in demand for an asset? Why should investors line up to invest their hard-earned money in a company, a house, an office complex, a barely-functioning antique sports car from the 1960s? The answer is actually very obvious – good news. But if you’re really good at what you do, it’s the expectation of good news you’re after.
Say Gab has her eye on a pharmaceutical company, Small Pharma Ltd. She’s closely following news about the company, both internal news (reported by the company to the market) as well as speculation she’s forming from her own independent research (e.g. through recently-filed drug patents). Small Pharma Ltd reported in their last trading update that they’re working on a new revolutionary covid-19 drug. The market downplays news of this drug but Gab is more optimistic. She invests on the expectation of good news. Sure enough a few months later, Small Pharma Ltd announces it has received TGA approval for its drug to be recommended by doctors for covid-19 treatment. The stock skyrockets. Why? This opens up a new revenue stream for Small Pharma Ltd. Gab knew that the drug (if approved) would be in high demand and would significantly boost Small Pharma Ltd’s sales figures.
Gab sells for a hefty profit and pools together enough money to put down a deposit on a house. Gab does her DD and invests into an up-and-coming suburb with cranes left, right and centre. The suburb is undergoing a huge public infrastructure boom. This is attracting jobs during the development process and she expects the projects will deliver thousands of permanent jobs in the area once the developments are finalised. A few years later, the suburb has become much more populous and there’s now much more demand in the market for her house because more families are looking to move closer to work.
In both examples, Gab had foresight – she was expecting good news. She expected Small Pharma Ltd’s treatment would receive TGA approval – a bold move considering the market clearly thought otherwise. Similarly she expected jobs growth and therefore a boost in population in the suburb in which she purchased her house.
And what about supply (or lack thereof)
Supply is a different and much simpler beast. Extending Gab’s real estate investment example, let’s assume demand stays exactly the same. 1,000 new families move into the suburb every year for 10 years. Our fancy equilibrium would require 1,000 new dwellings to be constructed every year for 10 years. However, developers (incorrectly) forecast that demand will drop and only construct 500 new dwellings per year for the next 10 years. Despite demand having not changed, house prices would jump because 2 families would have to compete for the same house (due to reduced supply) and this would drive prices higher.
What exactly is good news
Another excellent question. Guess I’m on a roll today. Good news differs depending on exactly what it is you’re investing in. For shares in most companies, it usually means better-than-anticipated profits. But this isn’t always the case. Take tech companies for example. Tech companies are infamous for skyrocketing in value despite posting (at least in the early stages) year-after-year of losses. This is because investors of tech companies appreciate that these companies offer the market a scalable solution. A mining company might be able to boost production by 10 or 20% every quarter depending on demand. A piece of software on the other hand can go from 10 users the first quarter to 1,000 the next to 100,000 the next (if of course there’s demand for it). There’s significant initial investment in a valuable product and on successful marketing and consumer take-up, the company’s user base can grow indefinitely and exponentially. Therefore, income isn’t as important for tech investors as is growth.
What about that barely-functioning antique sports car? You have to apply a layer of common sense to what you can consider good news and what might drive demand for the asset you’re investing in. In the case of la voiture, you would be gunning for the wealthy to get wealthier if you’re hoping to turn a profit here. Think about it – an antique sports car isn’t particularly practical nor is there much potential for it to deliver income in the interim, but it does have value in the sense that it’s a collectible. The ultra-rich collect pricey collectibles because it’s genuinely really, really hard to spend billions of dollars (if you’ve never tried to comprehend just how large a billion is – know that a million seconds is 11.5 days but a billion seconds is almost 32 years). So, good news for your mid-life crisis compulsive, auto-themed purchase, means the rich having loads of cash to splash.
We also need to factor in news which has nothing to do with the investment itself. External factors include interest rate changes, currency fluctuations, government policy, idk a pandemic I guess. Let’s do a quick case study. Sydney Airport was a stellar ASX-listed performer until February this year. The travel industry was ecstatic and Sydney Airport was frequently reporting good news. Alas, fate was unkind. A pandemic struck and the government closed its international borders. Sydney Airport’s traffic dropped a whopping 97% in the span of a month. It’s not Sydney Airport’s fault – the government literally said it’s not allowed to do business. This is ultimately something out of its control – external.
Your takeaway from the above should be that picking a good individual investment is an extraordinarily difficult task. It will involve substantial due diligence and even when you’re sold on an idea, you have to allow for some risk of unexpected internal or external news (good or otherwise). If you’re not yet confident enough in your abilities, see Diversification and ETFs for a more risk-averse option.
P.S. birkenstocks suck