6.4 Equities: supply, demand and price

Obviously the market’s valuation of a share involves a large amount of judge-

ment: about the future growth of dividends, about the appropriate risk premium and

about future interest rates. It is most unlikely that everyone will make exactly the

same judgements. Thus at any time, in the population of potential holders of a given

share, there will be those who think its current price just right, some who think it

too low and some who think it too high. If we vary the price, we shall vary the pro-

portion of potential holders of the share who will fall into these categories. As the

price rises, there will be a steady decrease in the number who think it undervalued.

If we lower the price, there will be an increase in the number who think it under-

valued. If we now add the rather obvious point that a person will buy the share only

if he thinks its present value exceeds or is just equal to its market price, we can see

that the number of buyers will vary inversely with the actual price. On this basis we

can envisage a demand curve for equities which is downward-sloping like those in

Figures 6.1 and 6.2.

In the UK, shares are held overwhelmingly by the institutions we looked at in

Chapter 4: life assurance companies, pension funds, unit and investment trusts. Until

1984 the personal sector had for many years been a net seller of equities. However,

during the 1980s, the government began a series of ‘privatisations’ – the conversion

of public sector organisations to private rms – and worked hard to encourage house-

holds to buy the shares issued with their conversions. Between 1984 and 1987 the

number of private shareholders rose from four million to nine million. Following

the stock market crash of October 1987 many of these shareholders sold out. As a

result, the proportion of total equities owned directly by households is very small

and the proportion of shares held by institutions has continued to rise.

The important point to remember, therefore, is that when we talk about willing

holders of the existing stock of equities, or about traders of marginal quantities of

the existing stock, we are talking about decisions being made by large institutions.

Indeed, when we talk about movements in the prices of individual shares (though

not when we refer to a general movement in share prices), we may be talking about

the decisions of a very few large institutions.

In markets as conventionally analysed, the supply and demand curves represent

the preferences of a very large number of individual decision makers. A change in

the preferences of any one buyer and seller cannot affect the market; only the com-

bined preferences matter. Plainly this is not true for the equities market, where one

or two decisions to buy or sell can have a signicant effect upon price.

The terms D, gand Kare sometimes referred to as the fundamentalsof a share’s value.

Accordingly, changes in the values attached to gand Kare referred to as changes in

a share’s fundamentals. Notice though that the fundamentals are not known with

certainty. The values of gand Kare estimates. Clearly, therefore, it is changes in those

estimates which are responsible for changes in the market’s valuation of a share. Of

course, a change in estimates may turn out, ex post, to have been entirely unwarranted,

but provided people believe at the time that the event is going to occur and they act

upon that belief, prices will change.

This poses an interesting problem for analysts and managers of funds. Imagine

yourself for a moment in such a position. The latest consumer credit gures are due

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Chapter 6 • The capital markets

to be published tomorrow. To do the best for your clients, you not only have to try to

anticipate whether the gures will be large or small but also to anticipate how others

will react. This in turn requires that you anticipate how others thinkthe central bank

thinks about the connection between consumer credit, interest rates and ination.

You may anticipate that the gures will be large. However, you may personally feel

that this has little relevance to future ination and you may even feel that the central

bank is likely to agree with you and leave interest rates unchanged. But that is hardly

the point. If general opinion disagrees with you and expects the central bank to raise

interest rates if consumer credit gures show a large increase, then prices will fall

tomorrow (regardless of what the central bank may do later). Unless you sell today,

your clients will make a capital loss. It will be no consolation to you, and certainly

no comfort to them, if in a few weeks’ time your interpretation of consumer credit

growth and ination turns out to have been superior to that of the market.