There are plenty of slick answers to give when clients ask what drives markets. The two most common, in my experience, are fear and greed or supply and demand.
Slick they may be but they have a relevance worth reflecting on.
Fear and greed are what make markets over-react.The irrational exuberance that drove shares to stratospheric levels as the new millennium started is a prime example of greed driving markets. The sell-off that followed the terrorist attacks of September 2001 demonstrated fear at work.
Supply and demand are more difficult to quantify. It stands to reason that if there are more shares available than the money to purchase them, the price is likely to fall, while an excess of cash chasing a limited supply will drive shares higher.
Ask a share dealer why the price of a share has risen and they will reply: “More buyers than sellers.” The so-called weight of money theory refers to the big institutional investors. The fact that pension funds and insurance companies have been redirecting cashflows away from equities into bonds, to reflect their potential liabilities, will have affected stockmarket performance in recent years.
The supply side is also measurable. The number of companies floating on the stockmarket or issuing new shares to finance expansion is a matter of record. Takeover bids can remove shares, as will the increasing trend by companies to return value to shareholders by repurchasing shares. This is published information but less easy to determine in terms of effect.
So, those seeking to offer investment advice should not dismiss these drivers. Imagine the effect they might have on underlying conditions, in particular, whether any surprises are likely to jolt the market in either direction. Recently we have had the most unexpected and unwelcome surprise of the tragedy in South-east Asia.
Doom merchants have long feared that an event of this magnitude would derail Far Eastern economic expansion. But while the tragedy is real enough, those areas affected are unlikely to have a wider economic impact although at local level the effect will be close to cataclysmic. In the long run, the aid pouring into the region should have a beneficial effect, which is why markets failed to react significantly.
Could other surprises occur? Of course they will. It is hard to foresee what shape they might take but we would be foolish not to watch the dollar and the way in which the US twin deficit problem is managed. The creeping centralisation of Russian business affairs is also a concern but doubtless there will be pleasant surprises as well.
Just remind your clients that uncertainty is ever present, which is why equities should be expected to provide superior returns to other asset classes in the longer run.