Asset prices in a free market, like all other prices, is determined by demand and supply. Thus, understanding both the demand drivers and supply factors of a particular asset is important if you want to figure out if the price is going up or down in the time frame you are looking at.
Supply factors are an entirely different discussion, so in this article I will only focus on demand factors. I believe there are 3 main demand drivers:
- Store of Value
- Expected Returns
Utility is the state of being useful. In other words, what is this asset used for?
A piece of property is useful because, depending on the type, you can stay in it, use it to conduct your business, produce something or farm some food. A car can be used to shuttle you from one place to another, while a truck can be used to deliver goods.
Currencies, whether fiat or digital, has the utility of being used as a medium for exchange. And this is an important utility because otherwise, we’ll all have to barter for all the goods and services we need, throwing us back to the stone age.
Because an asset is useful, people want to own it so that they can use it.
Store of Value
Inflation is a long-term economic reality we all must deal with. It is unavoidable because a small amount of inflation is necessary to keep the economy (and hence employment) close to full capacity. Therefore, the value of cash erodes over time, reducing purchasing power. Investors thus seek to park their cash into alternative assets whose nominal prices can increase at least at the same rate as inflation.
For example, John has $1 million dollars stashed under his pillow (maybe it’s a really big pillow!), which allows him to buy 200,000 Big Macs at $5 per burger. He believes that 10 years later, due to inflation, the Big Macs will cost $6. His $1 million dollars will only buy 166,667 Big Macs, indicating a loss in purchasing power.
But John believes that the price of gold will also appreciate by 20% in 10 years. So, he now wants to buy $1 million worth of gold bars, expecting to be able to exchange them for $1.2 million 10 years later, preserving his purchasing power at the equivalent of 200,000 Big Macs. John therefore contributes to the demand for gold, because he believes it is a good Store of Value.
But what if John wants to get rich by investing? At this point, his investment objective has switched from merely preserving purchasing power to making a profit. He expects the return on the asset to be higher than the inflation rate.
So instead, he may buy Apple shares, which he believes will double in price within the next 10 years. His expected return on investment has gone up from 20% to 200%! This adds to the Expected Return demand for Apple shares.
Asset Demand is the Sum of All Three Demands
The demand for a particular asset consists of all 3 sub-demands, coming from Utility, Store of Value and Expected Return. Aggregate demand (DA) is the aggregate of all the sub-demands (D1, D2 and D3). Thus, to figure out what the asset demand trend is, you have to analyze movements in each of the sub-demands.
The demand dynamics for different asset classes are quite different.
Gold has some Utility in jewellery, electronics and dentistry, and perhaps also as a medium of exchange. But quite clearly, most of the demand comes from Store of Value and Expected Return. In a bearish stock market, many buy gold on a flight to safety and mainly want it as a Store of Value. In a bullish gold market, relatively more buyers enter the market because of Expected Returns.
Real estate has strong demand from all 3 sub-demands. Those who buy it for their own use (whether as a home or for business purposes) are buying it for Utility. However, not everybody can afford to own the property, so there will also always be a need for investors willing to pump in the money and rent out the property.
In general, real estate is a good Store of Value, especially if it’s a freehold or leasehold with a long tenure. It also generates a consistent Return when you can collect rental on it, and potential windfall Returns if there is significant capital appreciation.
Motor vehicles are a depreciating asset the moment you buy them, so they have almost no use as a Store of Value, So all of the demand comes from Utility unless you’re talking about vintage or limited edition cars. Industrial machines are also 100% driven by Utility demand and 0% of the other sub-demands.
Ownership of a business, whether privately held or publicly listed, has no Utility for the shareholder. Yes, it makes a profit by providing Utility to its customers. But for owners who don’t consume the product/service, there is no Utility.
Therefore the demand for a particular business (or its shares) is driven 100% by Store of Value and Expected Returns. I would think it’s more for Expected Returns rather than Store of Value since I don’t think people want to own businesses that are merely surviving and keeping pace with inflation. Even the S&P 500 does more than 10% annual returns over the long term, which is way higher than inflation.
Fiat currency also has a mixture of all 3 sub-demands. Its main Utility comes from it being used as a medium of exchange. This can happen within countries (domestic consumption) and between countries (international trade). Currencies which are perceived to be more stable may also gain demand as a Store of Value in bearish markets when there is a flight to safety from riskier assets to safer assets. There are also forex traders who trade between different currencies, expecting the trades to make a Return.
Crypto assets, well this will be an interesting and controversial discussion.
A pure-play cryptocurrency like Bitcoin was invented from the beginning to be used as a medium of exchange and as a stable Store of Value by limiting supply. But to work as a medium of exchange, the currency must first have a stable value relative to goods and services i.e. it must have stable purchasing power.
Stability is essential for something to be used as a medium of exchange because merchants, whose costs are more or less fixed, will tear their hair out if their price fluctuates wildly relative to their costs. Bitcoin today is worth around USD 30,000. Can you imagine what happens if a car dealer sells his Kia Sportage for 1 BTC?
His landed cost for the car may have been USD 15,000. If BTC appreciates by 20% the next day, he will be priced out of the market and lose sales to his competitor, because the customer will keep his BTC (now worth USD 36,000) and spend USD 30,000 in fiat currency to buy the car.
If BTC depreciates by 20%, he will definitely sell the car, because his car is now 20% cheaper than his competitor. However, his profit would have dropped 60% from $15,000 to $9,000. Since he’ll never sell his cars when BTC appreciates, and he can only sell cars when BTC depreciates, overall, he will always make less money. He’d be better off pricing his cars in fiat USD instead.
However, as speculators started entering the market, BTC quickly appreciated. Most of the demand came from people who wanted quick, massive Returns. There was also huge volatility in BTC’s value (because Expected Return is the most volatile of the 3 sub-demands), negating its Utility as a medium of exchange. People who bought the BTC didn’t want to spend it either, because they believed it was going to have a massive appreciation in value.
Other crypto assets came along, among these were currencies native to blockchains that enabled smart contracts, such as Ether (ETH) and Solana (SOL). This allowed yet another class of crypto assets called Non-Fungible Tokens (NFT).
Cryptocurrencies that enabled smart contracts could theoretically also be used as media of exchange, but just like BTC, their values were simply too volatile to be used. However, they did have the extra Utility of enabling NFTs. All NFT transactions ultimately require gas fees (i.e. transaction fees), and they all need to be paid using the blockchain’s native currency (such as ETH or SOL). And as the NFT market grows, so does the Utility demand for these cryptocurrencies.
NFTs also come in many shapes and sizes, as well as many Utilities, with even more to come. Depending on the NFT type, the Utility could be aesthetic (e.g. digital art), social (part of an exclusive club), or contractual (e.g. tokenized assets). It can even be as simple as showing off (a.k.a. “flex”). However, just like other crypto assets, most of the demand, at least up till now, has come from Expected Returns.
Why is Demand Volatile?
I would postulate that Expected Returns is the most volatile, and the key driver of big rises and falls in the value of an asset.
Utility demand doesn’t change much that quickly. You won’t see the need for housing suddenly double unless your population miraculously doubles in a short time. There is an increased Utility demand for Electric Vehicles, but they’re not going to overtake traditional fuel-powered automobiles within the next 5 years. Traders like myself, on aggregate, buy more or less the same amount of USD every month in order to purchase goods to sell.
Unless there is a sudden shock, Utility demand for assets usually changes very slowly. An example is the COVID-19 pandemic, which increased the Utility demand for industrial machines that made masks and gloves manyfold.
Demand coming from those who want an asset for its inflation-hedging properties (i.e. Store of Value) should also be quite stable. Such buyers only want the asset to appreciate at the same rate as inflation, anything higher than that is considered a bonus. Hence, they won’t look at the prices every day and are prepared to go very long on the asset, like 10 years or more. They are not concerned at all about the daily price fluctuations and don’t get too emotional about them.
But a buyer who wants to maximize his returns tends to look at the price every day and follow news related to the asset closely. There is nothing wrong with this, it is what professional investors do as well.
However, when the market is flooded by buyers who are relatively inexperienced but still want the same (or better) returns than the pros, a lot of emotions come into play, especially FOMO (fear of missing out) and greed.
When the market is bullish, these buyers flood the market with demand driven by Expected Returns, believing that the market will keep going up. But when the prices get over-inflated, all it takes is a small shock, and the bubble is burst. Demand very quickly turns the other way. Extreme optimism becomes extreme fear.
Because demand from Expected Returns is driven mainly not by economics, but by emotions, which can change in an instant, it is the most volatile of the 3 demands, and the key driver of big swings in demand.
How Can this be Useful?
I think if you are evaluating an asset, its intrinsic value, in the long term, is driven by Utility and Store of Value. But in the short term, its price can be hugely distorted by Expected Return. Understanding the key demand driver of an asset, at any given point in time, can help you decide whether it’s the right time to get in, or perhaps, more importantly, the right time to get out.
Bitcoin was invented for the purpose of Utility, and designed to be a reliable Store of Value (by limiting supply). If its price grew slowly, given enough time, it could very well achieve its primary Utility of becoming a medium of exchange. As I pointed out earlier, stability in value is a necessary condition for a currency to become widely used as a medium of exchange.
The early followers saw this Utility and bought in because they saw that future. But as the price of Bitcoin increased, more and more people joined. Most believed, and possibly rightly so, that Bitcoin will eventually fulfil this destiny.
However, those who joined late and didn’t get out early enough (including myself), probably didn’t realize that it was primarily demand for Expected Returns driving prices up. This distorted the price of Bitcoin, creating a huge gap between its intrinsic value and price, resulting in an asset bubble. All it took was a pinprick, and prices came tumbling down.
I believe that there is a long-term future for crypto, especially NFTs. NFTs have the potential to create huge Utilities. But which NFT to buy? That’s the million-dollar question. Perhaps the NFTs that are worth buying haven’t even emerged yet.
But, most of the cryptocurrencies in the market right now need to be re-priced. As for what’s the right price, I don’t think anybody knows. What I do believe is that most of the demand for Expected Returns needs to be dissipated before the cryptos start trading at prices close to their intrinsic value.
Still, it is quite impossible to time the market. I am writing this in hindsight, after the LUNA/UST crash. But honestly, even if I transport myself back to 6th May 2022 armed with the knowledge that I have today (except hindsight), I might have been able to successfully identify that the crypto market was an asset bubble. But I might still have stayed in the market because it was still possible that the bubble could inflate some more. This is like blowing a balloon and trying to make it as big as possible without popping. But sometimes you just over-estimate the limit of the balloon, and it pops before you want it to.
I guess the main point I want to make here is that if you’re buying into an asset because you’re convinced of its Utility and as a Store of Value, be careful about the price you’re paying. It may be fundamentally a good asset and will appreciate in the long run. But in the short run, demand for Expected Returns can distort the market.
A good asset can still be a bad investment if you pay the wrong price for it.