How Does the Law of Supply and Demand Affect the Stock Market?

The law of supply and demand is a theory that seeks to explain the relationship between the availability and desire for a product, such as a security, and its price. Typically, low availability and high demand boost the price of an item and high availability and low demand reduce its price.

The law affects the stock market by determining the prices of the individual stocks that make up the market.

Key Takeaways

  • The law of supply and demand seeks to explain the relationship between the availability and desire of a product and its price.
  • In terms of financial markets, supply and demand determine the pricing of stocks and other securities.
  • Economic data, interest rates, and corporate results influence the demand for stocks.
  • Market dynamics, economic conditions and changes to economic policy tend to impact the overall supply of stocks.
  • Both the supply and demand for stocks tend to amp up in response to initial public offerings, spinoffs, or the issuing of new shares.

Factors That Impact Stock Demand

The major factors that impact the demand for stocks are economic data, interest rates, and corporate results. Economic data reveals information about the state of the economy. If the economy is doing better than expectations, it creates more demand for stocks in anticipation of better earnings.

Interest rate increases tend to lead to decreased demand for stocks as the risk-free rate of return rises. Of course, rates tend to rise when the economy is improving, which boosts demand for stocks, so these forces moderate each other.

Corporations' profits, sales, margins, and outlook have a massive impact on demand for individual shares, accounting for the volatility that emerges before and after they release their results for the quarter or year.

Short-term demand for stocks tends to accelerate around the release of corporate profit results and forecasts.

Stock Supply Changes Slowly

While demand for a stock can gyrate based on market dynamics, economic conditions, changes to central bank policy, and better-than-expected (or worse-than-expected) corporate results, the supply of stock tends to change at a glacial pace.

Companies can decrease their own supply of shares via stock buybacks or delisting. This is when the companies purchase their own shares at market prices, retire these shares and so decrease the number of existing shares overall. This leads to higher prices as long as demand does not decrease. Delisting often occurs when a company declares bankruptcy or goes private.

The supply of stock tends to change at a slower pace than the demand, which can pick up or drop in response to corporate news or other one-time events.

Ways to Boost Supply

Some ways that supply can increase include initial public offerings, spinoffs or the issuing of new shares. Private companies become publicly listed in initial public offerings, giving them access to public markets. Each time a new company lists, it increases the number of stocks that compete for investors' capital.

Spinoffs are similar to initial public offerings. Existing companies divest themselves of units, which become their own stand-alone companies.

Finally, companies in financial distress or in need of capital may issue more shares of stock. This leads to drops in stock prices as the overall supply of shares increases.