The stock price is determined by the market, and the seller’s supply meets the buyer’s demand. But have you ever wondered what drives the stock market—that is, what factors affect the price of stocks? Unfortunately, there is no clear equation that can tell us exactly how the stock price will behave. In other words, we do know something about the forces that drive stocks to rise or fall. These forces are divided into three categories: fundamental factors, technical factors and market sentiment.
- Stock prices are driven by many factors, but ultimately the price at any particular moment depends on the supply and demand in the market at that time.
- Fundamental factors drive stock prices based on the company’s production and sales of goods and services’ earnings and profitability.
- Technical factors are related to the price history of stocks in the market, and are related to the chart patterns, momentum and behavior factors of traders and investors.
In an efficient market, stock prices are mainly determined by fundamentals. At a fundamental level, fundamentals refer to a combination of two things:
- Earnings basis, such as earnings per share (EPS)
- Valuation multiples, such as price-to-earnings ratio
Owners of ordinary shares have a claim on earnings, and earnings per share (EPS) is the owner’s return on their investment. When you buy stocks, you are buying a certain percentage of the entire future income stream. This is the reason for the valuation multiple: it is the price you are willing to pay for future revenue streams.
Part of these proceeds may be distributed as dividends, while the rest will be retained by the company (on your behalf) for reinvestment. We can view the future income stream as a function of the current income level and the expected growth of the income base.
As shown in the figure, valuation multiple (P/E) or stock price as a multiple of earnings per share is a way of expressing the discounted present value of expected future earnings streams.
Although we use earnings per share (an accounting indicator) to illustrate the concept of a profitability basis, there are other profitability indicators. Many people believe that a measurement based on cash flow is superior.For example, free cash flow per share is used as another measure of profitability.
The way in which profitability is measured may also depend on the type of company being analyzed. Many industries have their own customized indicators. For example, real estate investment trusts (REITs) use a special measure of profitability called funds from operations (FFO). Relatively mature companies are usually measured by dividends per share, which represents the amount actually received by shareholders.
The valuation multiple expresses expectations for the future. As we have already explained, it is basically based on the discounted present value of future revenue streams. Therefore, the two key factors here are:
- Expected growth in earnings base
- Discount rate, used to calculate the present value of future income streams
A higher growth rate will allow the stock to obtain a higher multiple, but a higher discount rate will result in a lower multiple.
What determines the discount rate? First, it is a function of perceived risk. Risky stocks get a higher discount rate, while the discount rate is lower. Second, it is a function of inflation (or interest rates, so to speak). Higher inflation will result in a higher discount rate and thus a lower multiple (meaning that future earnings will become more valuable in an inflationary environment).
In summary, the key fundamental factors are as follows:
- Basic level of earnings (expressed by indicators such as earnings per share, cash flow per share, dividends per share)
- Expected growth in earnings base
- The discount rate, which itself is a function of inflation
- Perceived risk of stocks
If only fundamental factors determine the stock price, things will be easier. Technical factors are a combination of external conditions that change the company’s stock supply and demand relationship. Some of them indirectly affect fundamentals. For example, economic growth indirectly promotes revenue growth.
Technical factors include the following.
We mentioned it as an input for valuation multiples, but from a technical point of view, inflation is also a huge driving factor. Historically, low inflation has a strong negative correlation with valuation (low inflation drives high multiples, and high inflation drives low multiples). On the other hand, deflation is usually bad for stocks because it means the loss of a company’s pricing power.
The economic strength of the market and peers
Company stocks are often closely related to the market and its industry or industry peers. Some well-known investment companies believe that the combination of overall market and industry trends – not the company’s individual performance – determines most of the stock’s trend. (Research shows that economic/market factors account for 90% of this.) For example, the sudden negative outlook of a retail stock often hurts other retail stocks because “associated guilt” drags down the demand for the entire industry.
The company competes with other asset classes for investment dollars on the global stage. These include corporate bonds, government bonds, commodities, real estate and foreign stocks. The relationship between the demand for US stocks and its substitutes is difficult to figure out, but it plays an important role.
Incidental transactions are the purchase or sale of stocks motivated by factors other than the intrinsic value of the stock. These transactions include the execution of insider trading, which is usually pre-arranged or driven by portfolio goals. Another example is when institutions buy or short stocks to hedge other investments. Although these transactions may not represent an official “voting” for or against stocks, they do affect supply and demand, and therefore can affect prices.
Some important studies have been conducted on investor demographics. Most of them involve these two dynamics:
- Middle-aged investors, high-income earners who tend to invest in the stock market
- Older investors who tend to exit the market to meet retirement needs
The assumption is that the greater the proportion of middle-aged investors in the investment crowd, the greater the demand for stocks, and the higher the valuation multiple.
Usually, stocks only move according to short-term trends. On the one hand, rising stocks can gather momentum, because “success bred success” and sentiment will drive stocks higher. On the other hand, stocks sometimes operate in the opposite way in a trend and perform a so-called regression to the mean.
Unfortunately, because the trend is two-way, and it seems more obvious in hindsight, knowing that stocks are “popular” does not help us predict the future.
Liquidity is an important but sometimes underestimated factor. It refers to how much investor interest a particular stock has attracted. For example, Wal-Mart’s stock is highly liquid and therefore responsive to major news; ordinary small-cap companies are not. Transaction volume is not only a representative of liquidity, but also a function of corporate communication (that is, the degree to which the company receives the attention of the investor community).
Large-cap stocks are highly liquid-they receive good attention and a large number of transactions. Many small-cap stocks suffer almost permanent “liquidity discounts” because they are not in the investor’s attention at all.
Although it is difficult to quantify the impact of news or unexpected developments on companies, industries, or the global economy, you cannot say that it does affect investor sentiment. The political situation, negotiations between countries or companies, product breakthroughs, mergers and acquisitions, and other unforeseen events will affect stocks and the stock market. Since securities transactions occur all over the world, and markets and economies are interconnected, news in one country can almost immediately affect investors in another country.
News related to a particular company, such as the release of a company’s earnings report, can also affect the price of the stock (especially if the company releases it after a bad quarter).
Generally speaking, strong earnings usually cause stock prices to rise (and vice versa). But the stock prices of some companies that have not made that much money are still skyrocketing. This rising price reflects investors’ expectations that the company will be profitable in the future. However, regardless of the stock price, there is no guarantee that a company will meet investors’ current expectations of becoming a high-yield company in the future.
Market sentiment refers to the individual and collective psychology of market participants. This may be the most troublesome category. Market sentiment is usually subjective, biased and stubborn. For example, you can make a reliable judgment on the future growth prospects of a stock, and the future may even confirm your prediction. At the same time, the market may stay short-sighted on a piece of news, artificially keep the stock high or Low. Sometimes you can wait a long time, hoping that other investors will notice the fundamentals.
The relatively new field of behavioral finance is exploring market sentiment. It first assumes that the market is obviously inefficient in many cases, and this inefficiency can be explained by psychology and other social science disciplines. When psychologist Daniel Kahneman (Daniel Kahneman) received the 2002 Nobel Prize in Economics (the first psychologist to receive this honor), the idea of applying social sciences to finance was completely legitimized. Many ideas in behavioral finance confirm obvious skepticism: Investors tend to overemphasize easy-to-think data; many investors react more to losses than joy in equivalent gains; and investors tend to insist on mistakes.
Some investors claim to be able to use behavioral finance theory. However, for most people, this field is new enough to be an “all-encompassing” category, and everything we can’t explain is stored here.
Different types of investors depend on different factors. Short-term investors and traders tend to include or even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that technical factors play an important role. Investors who believe in fundamentals can reconcile themselves with technical forces through the following popular arguments: Technical factors and market sentiment usually overwhelm the short-term, but in the long run, fundamentals will determine the stock price. At the same time, we can expect more exciting developments in the field of behavioral finance, especially because traditional financial theories seem to be unable to explain everything that happens in the market.