Jan

9

Studying the factors that determine consumer demand is a fruitful area for sharpening stock and market pickings. The usual ideas are summarized in the Slutsky equation, which states that the change in demand with respect to price depends on the sum of the substitution and income effects. The substitution effect is greater to the extent that one good, (or the good under consideration relative to the market basket) is a close substitute for another. The effect is lower if the goods are complements. Indifference curves between two goods that are close look like straight lines and indifference curves between goods that are substitutes look like right angles.

The income effect of a change in price also depends on the percentage of the total income spent on the good, and whether the good is a normal or an inferior good. Inferior goods are those like potatoes or busrides, or in the old days, Spam, which we buy more of as our income decreases. Normal goods are things like cars or other durables, which we buy more of as our income increases. All these factors vary for different consumers as a function of their changing tastes, income levels, and preferences for risk. Such factors are all well covered in most good books on Price Theory, with the late Professor's book (Peter Pashigian's book, Price Theory and Applications) as my favorite. It has a very nice graphical analysis of almost all factors that determine consumer choice, and it gives many real life examples of industries and business situations where analysis of consumer and producer activity through the framework of choice and incentives leads to great insights into what is happening in the economy. I find the sections on inferior goods (demand for them increases as income falls) and Giffen goods (demand for them increases as price increases) are relevant to stock analysis. Stocks are often said to be Giffen goods because demand for them increases as the price goes up due to momentum, trend following and general herding.

To put some specifics on it, I propose to consider the inferior and Giffen stocks each day and week. I look at which ones go down when the market goes up, and which ones go up when the market goes down. How does this change over time in an individual stock? What are the inferior and normal goods relative to interest rates and GNP? How does the situation change with respect to changes in VIX? All these factors must be considered relative to their predictive properties, for example, what the future performance of the inferior, normal and Giffen goods are relative to this or that index?


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