Hopefully we all remember our economics classes. The first, most basic lesson is clearly imprinted in my mind. It looks like this:
This neat little graph explains a few central tenets of economics – demand for something rises when the price goes down and decreases when the price goes up, the price of something decreases when supply increases, and that price and quantity seek an equilibrium where supply and demand meet. We can think of countless examples of these phenomena in real life.
Now consider shares of Tesla (TSLA). We have witnessed the remarkable rally in the stock throughout most of its existence and are especially amazed by its recent performance. The stock is up about 70% since announcing a 5:1 stock split alone. Now consider the rationale behind that rally – that demand would increase when the price of the shares was cut by 80%. That might appear to make sense – demand should increase when the price falls – but remember that a split does nothing to change the market capitalization of the underlying company. In a 5:1 split, the price declines to 1/5 its prior level because the supply of shares increases by 5x. The price may have fallen, but the equilibrium between price and quantity is unchanged.
Yet that was not the case with Tesla or Apple (AAPL) in recent sessions. The stock prices rose sharply and steadily, meaning that demand was increasing as prices rose. That is the opposite of what basic economics teaches us. Effectively, all momentum trading is in opposition to basic rules of supply and demand. The number of free-floating shares changes little on any given day, yet demand often increases simply because price are rising. We see that all the time in financial markets, and TSLA is simply the most extreme example.
This morning, we were treated to yet another seeming violation of an economic fundamental. Before the market opened, TSLA announced a $5 billion share sale. Thinking back to our supply/demand curves, an increase in supply should cause a decrease in price. Though the stock has since fallen modestly, the initial reaction in pre-market trading was another sharp rise in TSLA. The psychology behind this stock at the moment is simply that all news is good news.
In the short-term, and sometimes the longer-term, psychology can prevail over economics. Over time the laws of economics usually prevail. But remember, these laws can often be broken with impunity, since only the market can enforce economic rules.
Disclosure: Interactive Brokers
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