In a nutshell, it’s the expectation of future returns that causes stock price movements. Lets look at what else causes stock price movements…
The Mechanics of Supply and Demand
No discussion on what causes stock prices to move would be complete without considering supply and demand.
A company has a number of stocks available for investors to purchase via the stock market. If the stock becomes popular with investors, they buy the stock. That’s an increase in demand. That results in less supply (less stocks available for purchasing). This causes the stock price to go up. If there are less stocks available to be purchased, then whatever shares are left in circulation, are worth more.
So, the buying causes the stock price to go up. Rising stocks tend to attract more buyers. Everybody wants a piece of the action.
If a particular stock becomes unpopular with investors the stock gets sold. More stocks become available for purchase on the stock market. So, demand goes down, supply goes up. There are more stocks available in the market, causing the value of the stock price to go down.
Selling tends to attract more sellers. The stock price goes down.
Factors affecting Share Prices
In the short-term, stock prices move according to “investor sentiment”. Investor sentiment is a collective term that represents the expectations of the majority of stock market participants.
People buy a stock because they expect its price to rise. People sell a stock because they expect its price to fall.
Investor sentiment can be either positive (rising stock prices) or negative (falling stock prices).
Note: We are not considering “short selling” in this article. Short selling is selling a borrowed asset with the intention of buying it back later at a lower price. You’ll here investors talk about “going short” or taking a “short position”. For the purposes of this discussion, we are only interested in “going long” – buying low and selling higher.
News regarding a company whether good or bad can affect a stock’s price. Favourable news such as positive guidance from a company’s management can cause a stock’s price to rise.
Guidance is when the management of a company make an official statement about the likely future prospects of their company. Usually it’s in the form of an estimate of what the likely sales or earnings should be for the next reporting period. Providing that management’s guidance has been accurate in the past, this can be useful information (we look at how to do this in the Stock Market Tutorial – Management Assessment).
Guidance can also be negative with a corresponding effect on the stock price.
Some announcements tend to be profoundly negative from an investor sentiment point of view. Certain events, more than often, cause a negative effect on a stock’s price. Things such as:
- dividends being cut or reduced
- negative growth estimates from management, or
- management or major shareholders selling the stocks they own
The major stock exchange websites and commercial finance websites such as Yahoo Finance (finance.yahoo.com) and MSN Money (moneycentral.msn.com) have a company announcement section for all publicly listed companies.
Analysts Earnings Estimates
When a company fails to meet analyst earnings estimates, the share price usually stumbles. For companies that are followed closely by analysts this is quite often the case.
For stocks that don’t receive much analyst coverage, the earnings forecasts might not have any effect. This is quite often the case with deep value stocks that have the bad news already built into the share price.
Economic statistics released by the relevant authorities can be favourable or detrimental.
Certain economic indicators such as interest rates, inflation, and unemployed figures may affect the whole market.
Or, a particular industry or business might be affected by the release of a specific piece of economic information, relevant to its specific business dynamics.
Over the long-term, earnings drive share prices. That’s why most investment analysis revolves around profits and factors that affect them.
One of the most important things to consider when analysing a company as a potential investment is whether the company has a history of making money.
We look at times in a company’s history when it was exceedingly profitable. We are looking for the factors that caused the company to flourish. This gives us clues about what we might be looking for at this point in time.
As investors, we need to realize that stocks represent ownership in real companies. When we buy stocks we become business owners. We need to think like business owners. We aren’t merely buying stocks, we are buying businesses. We want to buy a good business selling at a cheap price.
The Stock Market Tutorial Lessons in the ‘Back to Basics’ section provides an effective step-by-step method for analysing companies for their investment potential. Learn how to buy good businesses at the right price.
- An increase in demand causes stock prices to go up
- An increase in supply causes stock prices to go down
- Investor sentiment moves stock prices in the short-term
- Earnings drive share prices in the medium to long-term
- The release of a company announcement can cause stock price movements
- The release of key economic data can cause stock price movements
- The daily gyrations of the stock market are not a concern for investors with a longer investment time frame