“Many false predictions over the past century or more that we were “running out” of various natural resources in a few years were based on confusing the economically available current supply at current prices with the ultimate physical supply in the earth, which is often vastly greater.” – Thomas Sowell, Basic Economics, pg 29.

Our world is built around interpreting signals. Some signals are direct and clear such as the threat of violence from a barking dog or Russian nationalist. Others are meant to confuse and shape a desired outcome. Think of the non-venomous tree frogs and snakes that share color patterns with their venomous relatives. And yet other signals convey different messages to different groups whether intentionally or not. An example would be the fifty-year-old who buys a Corvette. To his spouse and friends, the Corvette symbolizes his youthful spirit, while all I see is a midlife crisis. A colorful metal chassis to delay the crushing weight of the universe and her temporal forces.

So signals are important! Which is why I’d argue of all our artificial creations, the pricing mechanism is the most important. Why? Because with zero background knowledge on a product, I can quantify how valuable the product is in the economy, whether the product is valuable enough to warrant purchasing, whether I need to fit it into my budget by removing another item or delaying another purchase, or if a less expensive substitute is available. All this information and possibilities conveyed with a few Hindi-Arabic symbols and a decimal point.

Now the cool part about pricing though is the countersignal you send back through your action or inaction. By choosing to buy something (or not) you and every consumer are sending a demand signal to suppliers. That signal can say: this item is very popular, no one wants this product, there is high demand but limited supply so we can earn excess profits, etc. We don’t see these signals when looking at the Lego sets in the Target aisle (scouting Christmas presents for my nephew, of course), but they’re what separate the price and quantity supplied of the Millennium Falcon Lego sets from Slave 1 Lego sets.

I think we all agree the free market works for pricing low stakes items like Lego sets, but what about the important stuff such as housing, health care, food, and natural resources? It’s always frustrating when goods, the quantity of goods, or life milestones* that were within your price range are pushed out of reach. Thankfully that same signal saying, “prices are going through the roof” is also telling suppliers “There is money to be made.”

Health care and housing are tough subjects to cover in less than 1,500 words so let’s focus on commodities for our example. In this case crude oil. Below we have two charts. The right chart depicts the oil industry’s supply, demand, price, and quantity as whole. The left chart shows an oil company’s price, average total cost, and marginal cost. As you can see, in the beginning there was heaven, Earth, and equilibrium.

Then a shock! Russia invades Ukraine and in response the West begins to cut-off Russian crude oil imports. This results in prices going up when demand remains constant. This increased price is destabilizing. Oil takes a larger share of the household budget, society must re-rate the importance of different goods in our collective budget, and people cry out that they are being fleeced by oil companies seeking to maximize profits.

Fortunately, those profits in excess of the previous equilibrium are a signal for oil producers and their competitors that there is money to be made. Each individual oil company has an incentive to produce more oil to maximize profitability along their marginal and average total cost curves. This means that idle refineries are spun up, production is maximized, and oil sands that were previously unprofitable are now profitable at the new price point. This works to increase supply.

But suppliers don’t wield all the power! Demand for oil can also go down. People don’t like to feel vulnerable and will insulate themselves from future price increases. This could be as simple as canceling out of town trips, buying smaller or electric cars, using a bicycle or public transportation, etc. Competing energy solutions also reduce oil demand since at the end of the day, energy is energy (subject to externalities). The result of all these complex interactions taking place behind the scenes can result in a glut of oil relative to the new demand curve. And now instead of “fleecing” consumers, oil companies are losing money on unprofitable projects and oftentimes going out of business.

This is in line with what we’ve seen with crude oil where prices are now below what they were a month before Russia’s invasion of Ukraine on February 24, 2022. This is in line with what we see during price spikes of items such as lumber and copper. Markets are dynamic and the pricing mechanism allows both consumers and suppliers to adapt quickly. Maybe not as fast as we always want, but fast enough to where supply concerns over the medium to long term are usually overrated.

What is the lesson? The ability for prices to fluctuate with supply and demand is necessary for a well-functioning market and counter-intuitively to some, necessary for change, usually positive change. It is only when people are faced with the direct costs of their decisions do people change and insulating people from that reality is counterproductive. Attempts to control prices through price control schemes, subsidies, complicated insurance markets with multiple intermediaries, and even interest rates can lead to unintended consequences and greater long-term pain even if they insulate consumers in the short-term. Because without rising rents how does a developer know to build more apartments and steal market share from their competitor? The answer is housing shortages and declining quality of existing infrastructure. How do we price a stock when the risk-free rate is zero? The market nukes it with a 50+% decline after re-teaching investors what a discount rate is. We should encourage policies and practices that enhance the pricing signal rather than garble it.

Post Credit Scene: How do we price stocks?

Though we don’t implement much individual security selection at HFG, I would put myself in the fundamental analysis camp. This means it is important to understand the characteristics of a company and its sector. My colleague Anthony has an excellent video looking at Beyond Meat but to sum things up, a company’s price is the market’s consensus of the present value of that company’s future earnings. An analyst’s job is then to look at a company’s present earnings, forecast its future growth potential and then determine whether the company is overvalued or undervalued relative to its current price. You may not agree with the market’s price for Beyond Meat, similar to how I don’t always agree with gas prices, but it’s difficult to outguess/outperform the market over time. However, that is a topic for another blog post.

*Author’s Note: There are a lot of problems with pricing that people blame on capitalism/free markets but are in my opinion the result of government policy (federal, state, local, your neighborhood HOA), socializing the wrong costs, and evolving tastes. For example, I’ve wondered why there aren’t more starter homes between 1,100-1,500 square feet since that was the average home size between the 1950s and 1970s, an alleged golden age of affordability. Then I remembered I didn’t look at any house less then 1,700 square feet for my home and I have never met someone who wanted an 1,100 square foot home (maybe this says more about the company I keep than anything else). I can pout about the lack of supply but I’m not contributing to a demand signal for these starter homes.

What I’m Reading and Watching

Growing a New Type of Organ Donor: Using genetically modified pigs to grow organ transplants is not a new idea (it was featured in Mr. Nobody), but interesting to see it receiving attention. Though I’m a sci-fi fan, I’m still not sure how I feel about this one. On one hand I eat animals that are born and destined for the food processor, but harvesting an animal for organ donation seems like an extra violation of animal self-determination or agency. That’s just my opinion. I’m one of those people that thinks history will judge us harshly for our treatment of animals even if I don’t plan to change my eating habits.

Who Will Inherit the Family Business? Often, It’s Private Equity: Private equity is interesting. There is definitely a need for it but it still very annoying to compete against. Still, this article provides a good explanation on when private equity can come in and grow a business.

The Last Days of the Dinosaurs: A couple people who have looked at my reading list have asked why my list is so varied. One even asked, “Why is a finance guy reading about dinosaurs?” Always be curious and build context! Stuff like dinosaurs, woolly mammoths, and outer space fascinate kids but for some reason most of us grow out of it. Which is a shame because the stuff that fascinated you as a kid is even more interesting to read about as an adult since you can comprehend it better and put it into context. I can’t recommend Steve Brusatte’s The Rise and Fall of the Dinosaurs enough and I will go out on a limb and recommend his new book The Rise and Reign of the Mammals even though I haven’t read it yet.