Baffled by Demand Destruction?

The latest pundit folly is the two-way interpretation of commodity price moves.

• When prices were spiking, it was a signal of impending doom:  spiraling inflation and eventual stagflation.  It showed that Ben Bernanke was clueless and that it would all end badly.

• With prices plumeting, it shows that we have "demand destruction," a signal of impending doom.  It shows that Ben Bernanke has been clueless, and it will all end badly.

No wonder the average investor is confused!

An Easy Guide to Demand Destruction

Normal Changes in Price and Quantity.  For any good there is a supply curve and a demand curve.  Let me consider the demand curve for gasoline.  Any specific  consumer will adjust the quantity purchased based upon the price.  If prices move higher, I might choose not to take a trip or to take other transportation -- even if less convenient.  If you total all of the individual decisions about fuel consumption, you get the demand curve.  If it changes a lot with changes in price, it is said to be elastic.

This is not demand destruction, but a normal (and perhaps temporary) market reaction to finding a clearing price where supply and demand intersect.  The behavior is movement along the existing demand curve.

Sustained Price Moves.  Sometimes there is a price move that has more than a temporary effect.  If, for example, people thought that we were moving into an era of higher gasoline prices, there would be a very different response.  The specific consumer might make permanent lifestyle changes -- trading in for a higher gas mileage car, selling a vehicle and switching to mass transit, or changing jobs to a location closer to home.  These permanent changes are very different from the first case.

These changes represent a shift in the demand curve, not movement along it.  The clearing price and quantity change, because the aggregate of individual preferences have changed.

We can say there has been demand destruction because there is a lower market clearing price at any given point on the supply curve.  The demand curve has shifted.

Illustrating the Point

There is some nice software to help in illustrating these problems.  Maybe I will do another version.  Meanwhile, I face my daily question.  This is an important issue which I will try to revisit with some cool graphs.

Investment Implications

Here is the biggest takeaway, one that I use daily in my investment management:

Higher energy prices are bad.  Lower prices are good.

Higher energy prices are a tax on the consumer.  Unlike most taxes, there is no public service benefit.

I am well aware of the (temporary) correlation between commodity prices and stock prices.  There are many reasons for this, not involving causation.  One of the first things taught in the class on causal modeling was to think.  There needs to be some plausible relationship before correlation implies causation.

In the richness of time we will see the following:

1. Stock prices will move higher with dollar strength, the normal long-term relationship.
2. Stock prices will move higher with lower oil prices, the normal logical relationship.

Spotting Bogus Advice

I had a long list of links with bad advice, but what is the point?  You need to learn to spot these on your own.  Feel free to add examples in the comments!

Any pundit that uses the term "demand destruction" to apply to the effect of higher gas prices on overall consumer activity is just being sloppy.  It is a tax, but the source does not understand what is happening.

Any pundit that talks about "demand destruction" based upon a change in gasoline or oil inventories is clearly mistaken.  This is movement along the curve, not a shift in the curve.

I have another indicator for which I invite reader commentary.  My hunch is that anyone citing "Econ 101" either did not take the class or does not remember it.  I cannot remember a helpful article that had that phrase.

I also did a search for "demand destruction" on the blogs that I regularly follow.  This includes a wide range of economists and pundits.  This term was used in a technically correct sense on only a handful of occasions.

Investment Conclusion

I understand that many people will see this article as technical, wonkish, and pedantic.  They will miss the point.

How can I explain?  If you are willing to let a bunch of pop economists sling around terminology that means nothing, you will never succeed as an investor!

The most popular "economic" blogs tell you things that you think you already know, reinforcing your beliefs.  It is possible to gain some investment advantage from real economists, but you need to have an open mind.

This means that on a day like today, you could use the lower energy prices to look for bargains in cyclical stocks, tech stocks, and financials.

 

Comments

[exMBB]

Very nice post!

My favorite example of bogus analysis is China:

If China's economic growth is higher than expected: Oh no!!! economy over-heating, impending market crash.

If China's economic growth is lower than expected: Oh No!!! China's economy is cooling, impending market crash

[oldprof]

Proteus -- Thanks for this accurate assessment of the situation. The political debate empowers the purveyors of anecdotes and pop economics.

Jeff

[Proteus]

Jeff:
I think part of the problem with the Econ 101 syndrome can be traced to politics mixing with economics. Even among well-known professionals in the field, we have Democratic economists, Republican economists, liberal economists, conservative economists, libertarian economists... This doesn't even include Keynesians, Austrians, and others. Many people see the substantial political differences among professionals as justification for extreme or illogical viewpoints without understanding just how much common ground there is in modern economic thinking.

While some people will never change, shame on professionals for not communicating better just how much progress has been made in economics.

On a different topic, I note that the approaching end of QE2 is being blamed for the selloff in stocks and commodities. A month ago these same people were saying QE2 had no effect. Hummmm.

[stock tips]

Lot of global tensions is going on at this time. Japan is expected to

pull out its money from the global market as they want to revamp their

country now. In current scenario anything can happen in the Share

market Investors are advised not to panic and stay invested only safe

traders and Stock Tips investors should exit their long positions on

every high and one can use every decline as an opportunity to enter

market again.
Regards
Stock

Tips