Just like the price of your car or your new couch, stock prices are determined by supply and demand. And, just like the case is for car and furniture prices, we don’t have an exact equation that tells us how stock prices will behave. We can, however, pinpoint some of the forces that move stock prices. These fall into three general categories.
1. Fundamental Factors
The primary factors that affect stock prices are called fundamental factors and refer to a combination of an earnings base (such as earnings per share, EPS) and a valuation multiple (such as the price-earnings ratio, P/E ratio). In this article, we will not go into fundamental analysis of stock prices, but a stock that exhibits strong fundamentals should see strong price growth. Since that is not always the case, especially in short term price movements of the stock that although its fundamentals are strong, its price may move down, let’s dive into the additional factors that affect stock prices.
2. Technical Factors
Technical factors are external conditions that affect the supply of and demand for stocks, and they include the following:
Not only does inflation impact the valuation multiple, it also affects stock prices in other ways. Inflation has an inverse correlation with valuations—for instance, low inflation drives high multiples.
The economic strength of market and peers
It is being argued that the main determiner of a stock’s movement is a combination of the overall movement of the company’s market and sector, not the individual company’s performance. Research shows that this factor accounts for 90% of the stock movement.
There are lots of other asset classes that compete for your investment dollars—including real estate, bonds, and commodities (such as precious metals). The exact relation is difficult to determine, but its role is unquestionable.
Some stock purchases are not motivated by the inherent value of the stock. These are called incidental transactions and include insider transactions. They don’t represent an official vote cast for or against a company and its stock, but they impact supply and demand nonetheless.
Researchers are looking into the demographics of investors. It is hypothesized that the greater the proportion of middle-aged investors (who tend to invest in the stock market) among the investing population, the greater the demand for equities and the higher the valuation multiple.
The stock market often exhibits short-term trends. Stocks may gather momentum, which is great for investors, but stocks may also trend the other way. Either way, trends are difficult to observe—we really only see them in hindsight—so they aren’t very helpful for investors despite their effect on stock prices.
Liquidity is determined by investor interest in and attention to a particular stock. Think about celebrity company founders like Elon Musk, and how his constant announcements drive up the price of his company’s shares. Highly liquid stocks are highly responsive to material news. Companies can affect trading volume (liquidity) through effective communication that drives investor interest.
3. Market Sentiment
When we’re talking about the psychology of the market participants (investors, companies, traders, etc.), we’re referring to market sentiment. While we know that this is a critical factor, we have only scratched the surface of what exactly market sentiment involves.
What we do know is that market sentiment is not only subjective but also biased. While you may have made solid projections about a stock’s growth, the market may keep the stock artificially low or high based on a single piece of news.
Since market sentiment is a significant, yet unexplored factor, researcher have started examining it. This relatively new field has been dubbed behavioral finance. It is assumed that, most of the time, markets are plagued by inefficiency, which researchers are attempting to explain via psychology and other social sciences. When psychologist Daniel Kahneman won the Nobel Memorial Prize in Economics in 2002, he essentially legitimized the field of behavioral finance.
We have long suspected that investors tend to overemphasize data that come easily to mind. We have also suspected that investors react more strongly to losses than to gains, and that investors tend to dwell on mistakes. Behavioral finance seeks to confirm these observations.
The Bottom Line
Investors rely on different factors, depending on their investment strategies. Long-term investors prioritize fundamental factors, while short-term investors look at technical factors. It is said that technical factors and market sentiment drive prices in the short term, but that fundamentals determine the long-term stock price. As behavioral finance slowly uncovers the forces behind market sentiment, we may realize that we should rely less on traditional finance theories. Regardless, we are going to see exciting developments in the field, and we’ll keep you updated on the latest news as always.