Are stocks directly proportional to supply and demand? If they are, would this mean that stock prices completely depend on HOW the public FEELS/THINKS about the stock instead of what it is actually worth?


Stock prices are indeed proportional to supply and demand. The greater the demand for a stock, the greater the price.

If they are, would this mean that stock prices completely depend on HOW the public FEELS/THINKS about the stock instead of what it is actually worth?

This is a question people have argued for decades. Literature in behavioral finance suggests that investors are not rational and thus markets are subject to wild fluctuation based on investor sentiment.

The efficient market theory (EMT) argues that the stock market is efficient and that a stock's price is an accurate reflection of its underlying or intrinsic value. This philosophy took birth with Harry Markovitz's efficient frontier, and Eugene Fama is generally seen as the champion of EMT in the 1960's and onward.

Most investors today would agree that the markets are not perfectly efficient, and that a stock's price does not always reflect its value. The renowned professor Benjamin Graham once wrote:

In the short run, the market is a voting machine but in the long run it is a weighing machine.

This suggests that prices in the short term are mainly influenced by how people feel about the stock, while in the long run the price reflects what it's actually worth. For example, people are really big fans of tech stocks right now, which suggests why LinkedIn (stock: LNKD) has such a high share price despite its modest earnings (relative to valuation). People feel really good about it, and the price might sustain if LinkedIn becomes more and more profitable, but it's also possible that their results won't be absolutely stellar, so the stock price will fall until it reflects the company's fundamentals.

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  • So the idea is to invest when a high(er) valued company is not well viewed and it's stock falls. Eventually, it should go back to what it's worth because in the long run the market fixes itself? – n0pe Aug 5 '11 at 14:16
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    Yes, that is the idea. We have seen this hold true for the last century, and it's reasonable to expect that to continue. I suggest you read about "discounted cash flow analysis" (DCF) to understand how stocks/companies are valued. A lot of the work is in projections, so if your early projections are wrong, you must readjust your target price. Also, sometimes a company can have very good fundamentals but a low stock price i.e. Microsoft. This can be because investors don't expect the company to grow like it used to, so they will not pay a high price. – BlackJack Aug 5 '11 at 14:20
  • The core issue here is how exactly you assign a value to something as complex as a corporation, which clearly has more than just the money it has in the bank. As with anything else, things are worth what people are willing to pay for them. You could make the same argument about used cars, or any tangible asset. There is nothing insidious about the idea that stocks (like everything else) are priced based on supply/demand versus some mathematical formula. – JohnFx Aug 5 '11 at 20:50

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