Why Stock Prices Change
Posted: Feb. 21, 2018, 10:03 a.m. by jprobasco
We know stock prices change. They go up and they go down. But why? What causes the movement? Of course, prices are determined in the market based on supply and demand. When supply is lower than demand, prices go up.
When demand is lower than supply, prices decline. There are, however, other factors to consider. The forces that move stock prices up and down fall into 3 categories: fundamental factors, technical factors and market sentiment.
Related: TWO TYPES OF STOCK ANALYSIS
The key to fundamentals is the intrinsic value of a stock or what the stock is really worth, versus the value at which it is currently being traded in the market. Earnings and earnings per share (EPS) represent your return on your investment.
When you buy a stock, you are buying a share of future earnings. This is where the valuation multiple (P/E) comes in. P/E represents the price you are willing to pay for future earnings. The earnings may come in the form of dividends or retained by the company (on your behalf) for reinvestment.
The valuation multiple (P/E) represents the discounted present value of a stocks future earnings stream. The factors used are the expected growth in earnings and the discount rate, used to calculate the present value of future earnings.
The discount rate is determined first as a function of perceived risk. A riskier stock earnings a higher discount rate which leads to a lower valuation multiple. Higher inflation earns a higher discount rate because it suggests higher risk.
Fundamentals are only part of the equation. Technical factors are external conditions that affect supply and demand when it comes to a company’s stock. Some technicals indirectly affect fundamentals. Inflation is a technical factor which, as noted above, also affects fundamentals. Another technical factor is economic strength of the market and peers. In other words, a company’s stock tends to track with the sector in which it operates.
Investment dollars also go into other asset classes such as bonds, commodities and real estate. To the extent those classes attract investments that can affect stock prices. Another factor is called incidental transactions which are transactions motivated by something other than the perceived intrinsic value of a stock. They could be insider transactions, institutional buying or even shorting a stock.
Finally, there’s the psychology of investors. Market sentiment can be subjective or biased or just plain obstinate. You might judge a stock’s future growth prospects one way only to discover sentiment drives it another. The factor that drives the stock in an opposing direction can be news that your fellow investors misinterpret or fixate on at the expense of everything else.
Market sentiment suggests markets are not efficient much of the time. This contrasts with the efficient market theory which suggests everything that can be considered is considered. Market sentiment as a pricing factor is new and not well understood.