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Supply, Demand, and Price Distension

Value

In the long term*, a correlation can be shown between company value (assets versus liabilities) and stock price. In the short term, market prices are not driven by value, but by the perception of value and the expectation of change. The short-term perception of value is a murky mixture of events, expectations. hopes, media spin, and recent price action.

Despite the haziness that surrounds the short-term perception of value, there seems to be good evidence for the existence of a transient sense of what is currently a reasonable price for any given security. I call this price the Consensual Market Value or CMV. Markets spend much of their time swinging back and forth aperiodically around their respective consensual market values.

CMV can be changed by news about the company, industry, or the economy. It can also be changed by a shift in public perception or by large flows of money such as might be caused by an influx of funds from institutional investors. CMV is seldom something you can point to and say, "There it is!" but it can be inferred by market action.

Price Distension

Distension of market price is essentially how far market price can diverge from CMV without changing CMV itself. A localized move in price is like stretching a rubber band. If you stretch it a little and let go, it will snap back. If you stretch it too much, it will break. Or if you stretch it and hold it for a long time, eventually it will adapt to being stretched and not snap back when released.

If you are attempting to enter a market when price has dropped and then profit from the upward price move as the market swings back up, it is critical to know the difference between a downward swing in price and a downward shift in price.

A downward swing is like an ocean wave. It is a move that is small enough in magnitude and short enough in duration to leave CMV essentially unchanged. It is a distension of price. On the other hand, a broadly-based downward shift or price breakdown is like an ocean tide. A change in the tide is a move that is big enough and/or long enough to carry CMV with it.

Major price shifts can lead to chicken-and-egg debates about whether CMV moved and price followed or price moved and CMV followed. Which moved and which followed can seldom be determined and is of no importance. What is important is this: If price moves down, can it be expected to swing back up or is it likely to continue to fall? The ideal situation for a swing trader is when price is pulled far enough from CMV to snap back forcefully, but not so far that it pulls CMV along with it.

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