October 5 2022 4:50 AM E-paper Subscribe Sign in My Account Sign out

Can demand actually cause prices to crash?

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(Photo: Pixabay)

You might have noticed that since the beginning of the year, all prices have been only going up, from commodities like oil, iron, copper, coffee and natural gas to stocks, indices, and bonds. This is also true for the prices of finished goods, real estate, services and gas at the pump.اضافة اعلان

In financial markets, like all other markets, there are correlations between different asset classes, some are positive (when the price of one goes up the second follows) and some are negative (prices of correlated assets move in the opposite direction). For example, the prices of precious metals like gold and silver are usually negatively correlated to the prices of high-risk investment instruments like the S&P500, while the prices of gold and silver are usually positively correlated meaning when one goes up the second usually follows.

Correlations are greatly important when building an investments portfolio — the less correlations between assets you are invested in, the less risk your portfolio has. Put simply, there is smaller risk for your entire portfolio to go down, because when one side of it goes down, another side would go up and balance out your portfolio. The process of investing in different asset classes is known as diversification, a primary rule for all investors across different markets to spread out risk and reduce the effect of different market crashes on the overall portfolio.

That being said, it is safe to say investors are always on the look out for different areas they can diversify their portfolios with and more assets within a single area to diversify with, so the demand for diversification is continuous.

Correlations exist in the real economy as well, not just in financial markets. For example, when people’s income grow so does their spending, and vice versa. In other words, as people make money they spend more, therefore, the GDP is positively correlated to spending, and in turn, demand is growing, and if the pace of demand grows faster than supply, prices go up.

Recently however, something weird has been happening; everything has been going up, which either means that there is demand across the board and people just want everything: They want to save and they want to spend, they want risk and they want safety. That sounds unreasonable, how can you want two opposite things? Well, the answer is simple, you don’t.

The price of gold going up in parallel with the S&P500 means that there is demand for both risk and risk aversion, which is outright unrealistic. What is happening in fact is that the prices are being reflected in a much more inflated lens, and the reason is something known as “FUD” (fear, uncertainty & despair). Governments are pouring money into their financial sectors, and in many cases, into the pockets of people, who are really afraid of the future and really want to save up for a rainy day. Nonetheless, they are witnessing rallies in the prices of stocks and commodities that are so big, they are begging for “FOMO” (fear of missing out). This causes people to take uncertain investment decisions, leading them to either jump in or jump out of investments prematurely, creating rapid changes in the prices (volatility).

Increased volatility causes weird things to happen, such as negatively correlated instruments moving in a parallel direction (gold up = S&P500 up). It is in human nature to want to have rules and principles, even if they are made up ones with no substance, and I’m not saying gold and stocks aren’t correlated, I am just saying humans need buffers to reduce doubt to as little as possible, after all, we did invent the zero, because we needed its nothingness to make us just a little more confident that a two is really a two and a three really is a three! When humans see rules and principles on which their beliefs are built break, they begin to feel a huge sense of despair; they feel lost and confused, making them less rational and more prone to mistakes. This reduced confidence in investment choices usually leads people to slow down and gradually begin to take less steps forward, making prices (demand vs supply) much more elastic.

In closure, people have developed huge demand for safety, but they also don’t want to miss out; they behave like a child playing hot potato, which leads to the magnification of both price rallies and price crashes. Given historical incidents in humanity where FUD was this high, the crash is usually the most likely and most intense outcome, so be weary of unjustified price rallies.

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