What 'demand destruction' means and how it fits into our investment strategy

Published Fri, May 20 20226:13 AM EDTUpdated Fri, May 20 202211:23 AM EDT

The Investing Club is all about education. So when we receive multiple questions on a topic from members — and one unenlightened editor — we have some explaining to do. A question that's been popping up lately: What do the pros mean when they talk about "demand destruction" and why is it so incredibly important we get some? We hear you, but before we can discuss the concept in more detail, we must first understand how prices are determined. Welcome to Economics 101. At the heart of all economics is supply and demand. That goes for the labor market, and it goes for a market of goods such as, say, semiconductors or oil. How prices are fixed for that labor or those goods will always come down to basic supply and demand. This concept can best be illustrated using a series of pricing graphs. Supply & Demand — free market On the Y-axis (the vertical one on the left) we have price. On the X-axis (the horizontal one on the bottom) we have quantity. The demand line slopes from the upper left to the bottom right, and the supply line goes from the bottom left to the upper right. The intersection of those two lines (demand and supply) is where we find "equilibrium." In a totally free market — that's unrestricted by supply chain bottlenecks and doesn't have things like taxes or subsidies impacting demand — that equilibrium point determines the quantity (Q1) suppliers will produce and the price (P1) buyers will pay. The issue we face today: While demand has remained elevated and steady, supply has become tighter due to breaks in the supply chain. This break can be found all over the global markets: semiconductor production, not enough oil production, China's Covid shutdowns, labor shortages, and so on. To illustrate this tight supply, we shift our supply line to the left as moving left on the X-axis indicates a lower quantity of supply. Supply & Demand — supply constrained market As we can see above, this small shift in supply — with no change in demand — creates a new equilibrium point at which we see a higher price level (P2). There are only two ways to get prices back down from the P2 level toward the original P1 level (or at the very least stop prices from rising even higher). One option is to increase supplies again — a move that will bring us back to the old equilibrium, or at least a point close to it. The other is to destroy demand. The first option is out: There is nothing the Federal Reserve can do to increase supply. It can't force China to open its factories or make more container ships appear out of thin air. Therefore, the only option left is to destroy demand. How is that done? By draining liquidity out of the market through interest-rate hikes (which impact shorter-term rates) and a reduction in open market purchases of bond securities (which impact longer-term rates). The Fed needs to pull dollars out of the economy and raise the cost of borrowing — the exact opposite of what happened in 2020 with the economic stimulus. Supply & Demand — supply constrained with demand destruction By lowering demand, we can reach a new equilibrium level (marked in red). Here we find lower prices (P3) that are in line with the quantities suppliers can produce in this current environment. We can destroy some demand to meet the lower production of supplies. We also achieve the goal of bringing down prices (or at the very least reducing the rate of inflation). This is how the current Fed is trying to bring inflation back down to its 2% target rate. Whether this can be done without pushing the economy into a recession, by achieving a so-called soft landing, remains to be seen. But in the long run, we're better off in a temporary recession than an economy with runaway inflation. This results in the destruction of buying power that's incredibly difficult to rebound from. 'Demand elasticity' One last concept that impacts how we approach investing in this market when we know the goal is to reduce demand, is to be very mindful of "demand elasticity," or the change in demand resulting from a change in price. If a good is very elastic, it means the consumer can do without it and will quickly demand less as the price rises. On the other hand, if a good is highly inelastic, it means that the consumer will pay the increased prices and minimal demand will be lost. One example of an elastic good is soft drinks; at some point, most consumers just aren't going to keep paying up for a bottle of soda. Sure, they may accept a small increase here or there but at the end of the day, it is a luxury that most can survive without. This is why the Club seeks out companies that have pricing power, even in bad economies. Conversely, lifesaving medication — like drugs manufactured by Club names Eli Lilly (LLY), AbbVie (ABBV) and Johnson & Johnson (JNJ) — is about as inelastic as it gets. Even if prices were to double, most consumers will cut other expenses (like soft drinks) first to ensure they can stay healthy. Energy is another example of an inelastic good, since it's not only required to get around but also serves as the main means of producing most goods. That's where oil and natural gas names — including Club holdings Pioneer Natural Resources (PXD), Devon Energy (DNV) and Coterra Energy (CTRA) — can benefit. Consumer staple stocks also have a degree of inelasticity, and Club name Procter & Gamble (PG) is the powerhouse of the group. While P & G does run the risk that people will turn to cheaper toothpaste, laundry detergent and shaving products, we believe its superior brands such as Crest, Tide and Gillette allows it to raise prices to combat business cost inflation without appreciable loss of market share. Although these products may come at a higher upfront costs, investments in innovation can actually make them more competitive on a per-use basis Even cloud computing and cybersecurity would represent examples of inelastic goods, though perhaps not to the same extent as life-saving medication. Cloud computing is fast becoming the backbone of global productivity. Good luck running a business if your data is hacked into regularly. Our Club names with robust cloud units include Amazon (AMZN), Alphabet (GOOGL) and Microsoft (MSFT). To be clear, some businesses of these companies are more elastic. Think Amazon's e-commerce unit, Alphabet's hardware business, or Microsoft's personal computing segments. Many of our other tech holdings are exposed to the cloud, including Salesforce (CRM), which offers cloud-based solutions that help companies run their businesses more efficiently. Then there are those goods that fall somewhere in the middle of the elasticity spectrum. One example is iPhones. Brand loyalty provides Club name Apple (AAPL) with significant pricing power, but it's not the inelasticity found for oil or medication. When times get tough, iPhone consumers may look to extend the life of their phones. So, while we certainly maintain our "own it, don't trade" view of Apple, we must be mindful that in these uncertain times, broad demand destruction can impact sales for even the greatest consumer products. Bottom line Companies that boast inelastic goods are where we want to focus our buying power in the face of uncertainty and a Fed intent on destroying demand. That is why we continue to focus heavily on energy, healthcare, and consumer staples — taking shots at other sectors only when the long-term value is too great to ignore. These are usually companies we believe will ride out a tightening cycle and are positioned to capture an outsized amount of economic activity once we recover. (Jim Cramer's Charitable Trust is long AAPL, ABBV, JNJ, LLY, PXD, DVN, CTRA, AMZN, GOOGL and MSFT. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trad