Financial markets are governed by the interplay between supply and demand and are especially subject to the psychology of market participants. Physical laws of nature tend to play less of a role. The pull of gravity accordingly is in force only to a limited extent. But as so often happens, there are exceptions to the rule.
The investment year drawing to a close provides an enormous amount of (price) data with which to investigate the question of to what extent Newton’s law of gravity applies to the financial markets. In the case of equities, gravity theoretically doesn’t have to exist at all on stock exchanges. On the contrary, stock prices can and should tend to rise over the long run. If an enterprise sustainably grows its revenue and earnings, a rising stock price (and an appreciating valuation) is warranted and all but inevitable. Sometimes, the power of imagination regarding the earnings potential of an (entrepreneurial) idea is enough by itself to cause a stock price to rise. But when stock prices climb exponentially, their distance to fall not only increases, but so does the probability of a sharp correction occurring. A textbook example illustrating that what goes up excessively (and especially too quickly) must come down again was presented this year right off the bat in January with the media hype and share-price gyrations surrounding GameStop. Within a span of just one week, GameStop’s share price rocketed more than tenfold. The price explosion was caused by a classic short squeeze, which occurs when market participants who were betting on a falling stock price get caught on the wrong foot. If, contrary to expectations, the stock price climbs higher and excessive (book) losses accumulate and the bank threatens to issue a margin call, the short sellers are forced to cover their short positions (practically) regardless of at what price, which temporarily drives the stock price even higher. Once the short sellers are finally squeezed out of the market, the stock price usually collapses, often leaving a Christmas tree-like pattern on the price chart. This was also the case with GameStop, where the gargantuan price spike in the space of just one month was followed by a 90% nosedive. But GameStop’s share price took a less typical trajectory afterwards because there was another short squeeze in March. The management of the videogame retailer took advantage of the favorable situation – i.e. GameStop’s inflated stock price – by issuing new shares in April and using the proceeds to retire debt. GameStop’s balance sheet is in sound condition today, but its business operations remain barely profitable and the company’s valuation is beyond ambitious. Since almost all of the short sellers have fled the stock by now, it would take an overhaul of the business model (and/or lots of speculative imagination) to push GameStop’s share price higher.
US construction lumber and natural gas
Classic “Christmas tree patterns” are even more frequently observable on commodity price charts than on equity markets. Commodity prices can spike sharply within a short time when supply and demand are in disequilibrium and there are actual physical shortages. But after a certain point, demand often subsides because the price for buyers becomes too high and/or supply increases because it becomes lucrative for sellers to step up production. Prices then often fall relatively quickly as a consequence. How strong this force of gravity is in reality depends on the specific commodity market in question, its seasonality and especially its supply-and-demand elasticity. Buyers’ sensitivity to changes in prices and vendors’ production capacities are key variables here. That’s why there are more “Christmas trees” in agricultural goods markets (in a broad sense) and energy markets and fewer to be found in (precious) metal markets. A majestic Christmas tree pattern was observable this year on the price chart for US lumber. On one hand, record-low mortgage interest rates and government stimulus checks stoked torrid demand for newbuild housing and home renovations, and on the other hand, production and delivery bottlenecks in the lumber industry resulted in supply shortages. This caused the price of lumber to triple from November 2020 to May 2021, after which it retreated by two-thirds in a span of just three months. Another commodity example may be playing out at the moment on the market for European natural gas. At its summit, its price increased more than sixfold since the start of 2021. Here, too, this was caused by a supply-and-demand mismatch. High volatility and sharp price peaks were repeatedly observable on the natural gas market in the past, and this time is unlikely to be any different.
Not just at Yuletide
Christmas trees on price charts
Price performance of various assets
Sources: Bloomberg, Kaiser Partner Privatbank
Any discussion of volatility and price pinnacles of course cannot leave out Bitcoin. Its price likewise lurched up and down on a roller coaster ride again this year. However, it’s not short squeezes or physical scarcity that often prodigiously move prices and inflame passions in the cryptocurrency space. The driver instead is an ongoing conflict between two camps pitting devotees of a (purported) technology of the future against critics who view Bitcoin and the like as being nothing more than a perfect case example of the “greater fool theory.” We’ll continue in the years ahead to keep a close eye on which camp gets proven right in the end.