What drives the price of a stock up or down?
From the opening of markets to the close of markets, stock prices fluctuate constantly.
Everything from a news story to a shareholder meeting can have an impact on a stock’s price. Often times, it has to do with supply and demand, as we saw during the infamous GameStop wave, when a collective of small, individual traders drove up stock prices. While some lucky traders were able to sell the stock at its peak and profit, many traders were hoping to make money quickly instead of losing money when the price finally fell back.
No one can predict every element that goes into stock price fluctuations, although many do try. That’s all the job of a hedge fund trader: trying to pool money to maximize returns on investment, while predicting – or influencing, some say – what the market is doing.
The ordinary investor is not going to spend all day watching the charts rise and fall. That is why at NextAdvisor, we support a more passive approach to investing and recommend that investors buy and hold index funds, including mutual funds and ETFs, which encapsulate broad compositions of securities s ‘spanning multiple sectors and markets, rather than individual stocks.
One of the advantages of investing in index funds is that you can start building wealth even if you don’t have a lot of technical knowledge of the stock market. But for investors interested in adding individual stocks to their portfolio, it can be helpful to have a basic understanding of how to research stocks and monitor stock prices. It starts with paying attention to the news cycle, market conditions – and even your gut feeling.
Here’s what you need to know.
What factors are driving stock prices?
Almost any day-to-day event can influence stock prices. The market, after all, is a reflection of how businesses and industries are valued in our society. Being the fickle creatures that we are as human beings, our ideas of worth are changing all the time.
Investing always involves some risk. That’s why it’s a good idea to spread your investments among many different stocks.
Everything from a PR crisis to the latest company news can impact the price of a stock. When investors, especially at the hedge fund level, feel there is cause for concern, we can see this drama unfolding in the stock market. The same happens with factors such as the Federal Reserve’s interest rate policies, geopolitical events such as wars and boycotts, and even factors such as innovation and technology, such as hype. media that we are currently seeing around cryptocurrency.
“A lot of these factors can be attributed to ‘noise’ and increasing daily price volatility,” says Jim Plumb, vice president and senior analyst at Illinois-based consulting firm RMB Capital.
But one factor influences stock prices more than any other: profit.
“Over the long term, stock prices converge to the present value of future cash flows generated by the underlying business. Ultimately, these fundamental factors will have the greatest influence on stock prices, ”Plumb explains.
Going forward, we explain how many factors interact to influence stock prices.
The two most fundamental factors come down to profitability and valuation ratio, says Juan Pablo Villamarin, CFA and senior investment analyst at Intercontinental Wealth Advisors.
“Profit is the end result of many sub-factors – revenue potential, managerial competence (like governance, skills) and cost management,” Villamarin said. “Although slightly more abstract, the valuation ratio is the relationship between some financial measure (such as earnings, income, cash flow) and the market value of the entity.”
The best known measure is the price / earnings ratio – or P / E -. The AP / E ratio is the ratio of a company’s share price to its earnings per share. Investors use these ratios to compare the performance of similar companies with a company’s records, both historical and projected profits.
Technical factors are things that change the supply and demand for the stock that won’t fundamentally change the prospects for cash generation, Plumb explains.
“Take a stock split for example,” he says. “If XYZ Company traded at $ 100 per share with a total enterprise value of $ 100 million and offered a 2-1 stock split, the shares would now trade at $ 50 but the full value of the company would not change since twice as many shares are now available. ,” he explains.
Even though this is a stock split, Plumb says some investors are drawn to the price drop, even though the fundamentals of the company haven’t changed.
Technical factors can also include the time of day or specific days of the week a transaction takes place versus other days and times, says Villamarin. In addition, the movement of the price of one stock relative to the movement of another stock in the same industry or line of business can also influence the price of the stock.
“These technical factors can be important because they provide insight into the supply and demand dynamics of the stock,” Villamarin explains. “There are certain factors that can reflect and predict future demand for a stock,” he says.
Trends, both historical of the company and of the industry as a whole, are considered technical factors.
If you’ve ever seen a company’s stock price go up or down as a result of a call for earnings, it’s because of the news.
“The trick is to decipher the news that can impact the fundamentals versus the noise that can alter the short-term supply and demand of a stock,” Plumb explains. “News that changes the likelihood of a company’s ability to generate future cash flow can have a major impact on pricing, especially if the impact is significantly different from current expectations.”
Quarterly earnings reports can cause the stock market to go down and up, although the effects are not always straightforward due to the myriad of factors involved in determining stock prices. In January 2021, for example, Apple stock prices fell despite the company posting record quarterly profits.
Things that happen in the world at large can also affect stock prices. Amid the COVID-19 pandemic, the stock market as a whole has suffered some significant declines. The first was in March 2020 and the most recent was this summer, as the Delta variant surged across the country causing traders to worry about the market recovering.
Market sentiment, or investor sentiment, is investors’ perspective on the performance of a particular stock in the market. Sentiment drives demand, which also influences supply.
“It is used to describe market expectations for portions of financial market metrics,” says Villamarin. “Market sentiment matters deeply because, at the end of the day, the forces of supply and demand are essential for the medium-term movement of asset prices. Psychology is essential to market dynamics.
There are several theories that attempt to explain how market sentiment can influence supply and demand for stocks:
Behavioral Financial Theory: This theory examines psychological factors when analyzing financial markets. Some investors act out of emotion and, in some cases, overconfidence in a particular security or asset. These reactions can lead to biased investment decisions, which could harm your investment.
The theory of the animal spirit: This theory assumes that people act instinctively in situations of uncertainty, the same way animals operate. In turn, actions – like making moves in the stock market – are also driven by instinct. When the market is good, investors buy. When the market is bad, investors sell. Even if instinct is not necessarily the right one, it is a driving force in decision making.
“In times of greed, market participants believe that stock prices will continue to rise and are willing to pay ever higher prices for stocks,” Plumb said. “Greed eventually turns to fear as investors start to realize that expectations have grown too high and start selling stocks,” he adds.
Plumb says we can measure market sentiment using the CBOE Volatility Index (VIX), or “the fear index”. The higher the VIX goes, the higher the fear of traders. The lower the VIX, the less fear. When the market is stressed, the VIX goes up. The VIX averaged 15.4 in 2019, but hit a near-record high of 82.69 at the start of the COVID-19 pandemic in March 2020, according to Reuters.
By using your instincts and intuition when investing, it’s easy to let your emotions get the best of you. Keep in mind that even with careful research, investing still comes with inherent risks. It is a good idea to diversify your portfolio as much as possible, in order to spread your risk over several investments. An easy way to do this is to invest primarily in ETFs and index funds instead of individual stocks.
Index funds and ETFs are great ways to build wealth with relatively low maintenance and low barriers to entry. If you also want to invest in individual stocks, it’s always a good idea to do your research and educate yourself on the past and potential performance of a stock before buying anything.
Ultimately, while the stock market can experience short-term ups and downs, investing is a great way to build long-term wealth. Make sure you invest smartly with a strategy that suits your financial goals and focus on your long-term goals (like saving for retirement) to avoid making hasty decisions based on short-term panic or fear. to miss out.