- Stock prices are determined in the marketplace, where seller supply meets buyer demand
- Unfortunately, there is no clean equation that tells us exactly how the price of a stock will behave
- The forces that move a stock up or down: fundamental factors, technical factors, and market sentiment
Fundamental factors drive stock prices based on a company's earnings and profitability from producing and selling goods and services
In an efficient market, stock prices would be determined primarily by fundamentals, which, at the basic level, refer to a combination of two things:
- An earnings base, such as earnings per share(EPS)
- A valuation multiple, such as a P/E ratio
Technical factors relate to a stock's price history in the market pertaining to chart patterns, momentum, and behavioral factors of traders and investors.
Market sentiment refers to the psychology of market participants, individually and collectively.
This is perhaps the most vexing category. Market sentiment is often subjective, biased, and obstinate. For example, you can make a solid judgment about a stock's future growth prospects, and the future may even confirm your projections, but in the meantime, the market may myopically dwell on a single piece of news that keeps the stock artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.
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Things would be easier if only fundamental factors set stock prices. Technical factors are the mix of external conditions that alter the supply of and demand for a company's stock.
Inflation
Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples and high inflation drives low multiples). Deflation, on the other hand, is generally bad for stocks because it signifies a loss in pricing power for companies.
Economic Strength of Market and Peers
Some investment firms argue that the combination of the overall market and sector movements—as opposed to a company's individual performance—determines a majority of a stock's movement.
Substitutes
Companies compete for investment dollars with other asset classes on a global stage. These include corporate bonds, government bonds, commodities, real estate, and foreign equities.
Incidental Transactions
Incidental transactions are purchases or sales of a stock that are motivated by something other than belief in the intrinsic value of the stock. These transactions include executive insider transactions, which are often pre-scheduled or driven by portfolio objectives. Another example is an institution buying or shorting a stock to hedge some other investment.
Trends
Often a stock simply moves according to a short-term trend. Unfortunately, because trends cut both ways and are more obvious in hindsight, knowing that stocks are "trendy" does not help us predict the future.
Liquidity
Liquidity is an important and sometimes under-appreciated factor. It refers to how much interest from investors a specific stock attracts.
News
While it is hard to quantify the impact of news or unexpected developments inside a company, industry, or the global economy, you can't argue that it does influence investor sentiment. The political situation, negotiations between countries or companies, product breakthroughs, mergers and acquisitions, and other unforeseen events can impact stocks and the stock market.
Conclusion
Different types of investors depend on different factors. Short-term investors and traders tend to incorporate and may even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that technical factors play an important role.