We all want to make money in the stock market. We do so by selling stock at a price higher than what we buy it for. It makes sense, then, that to make money in the stock market, we need to understand what causes prices to change. By having an appreciation for the things that motivate stock price change, we can be better at anticipating the direction and velocity of price moves.
What is Price?
To begin, we must first understand what price is. Financial theorists define stock price as the present value of all future earnings expectations for the company, divided by its number of shares outstanding. What this means is that the earning capacity of the company is what defines price. Often, companies can get significant value out of a relatively small investment in assets because the ability for those assets to make money is significant.
Even companies that lose money today can have a high share price because price is based on the future earnings of the company. No enterprise is in business to lose money, so the expectation is that every business will make money some day. So long as there is the potential for future revenue streams to shareholders, there will be a price that someone is willing to pay for the shares.
The earnings that a company could make in the future, the growth that the company could realize and the time to the realization of those goals are all factors which affect the estimate that the market makes on the earnings potential of the company.
The Market Mechanism
The value of publicly traded shares is liquidity. Publicly traded companies are worth more than private ones simply because there is greater access to buyers and sellers, and market efficiency can better determine share price. The stock market provides value to any company that chooses to list its shares because the company gains liquidity.
In a theoretical sense, any time someone buys the shares of a company in the market, they are effectively stating that they believe the shares of the company are undervalued. The fact that they are buying implies a belief and expectation that the shares will increase in value in the future. At the same time, the person who is selling the shares is expressing the opposite belief. By selling, they imply that the stock is overvalued and the expectation that the stock will go lower in the future. In this way, the stock market is forum for debate on what the value of the company and its shares is.
What Affects Price?
There are four factors that cause movements in stock price:
It is important to understand how information flows from the company to the public. The public is supposed to learn about significant new information through the issuance of news. The reality is that the information usually makes it out before the news is released. Rumor plays a big part in the flow of information, particularly today when technology allows for the rapid and wide dissemination of information. Those close to a company often have access to privileged information that they act upon by buying and selling in the market.
The ramification of this is that investors who wait for news to make investment decisions often get into stocks long after the information contained in the news has already been priced in. "Buy on rumor, and sell on news", is a saying that has grown popular because it is often the case that stocks move up in anticipation of positive news and then sell off when expectations have been answered by the news release.
Technical analysis is very useful because it provides tools that allow investors to identify the signs that new information is being priced into a stock before news is released. Stocks that trade abnormally often do so because of significant new information, both positive and negative. In this way, technical analysis helps to reveal fundamental changes in the company before the broader market is aware of it.
Companies that have established a performance record will tend to show less volatility as determined by uncertainty. General Motors, which is a well-established company with many years of revenues, will show less volatility than an upstart technology company that has not yet had an opportunity to establish a track record of revenues and earnings. Because of uncertainty, these stocks will trade differently and will present different kinds of trading opportunities.
For example, greed often causes stocks to go higher than they deserve to go. By deserve, I mean that they go higher than the present value of future earnings potential can justify. New information can cause a frenzy in the market that makes investors lose sight of rational valuation and simply buy the stock for fear of being left behind. This phenomenon is the basis for some great speculative bubbles that we have see in history.
At the same time, fear motivated by negative information can cause everyone to rush for the exit door at once and take a stock, or entire markets, dramatically lower very quickly. Much of the selling pressure that prevails during market crashes is out of fear, not a rational thought process based on information.
Fear and greed present incorrect valuations in the market that can exist for relatively short periods of time but long enough for smart investors to capitalize on. Emotion in the market can be viewed as an amplifier for new information. It can make moves more extreme than they should be. However, often the power to this amplifier is pulled and the stock moves back to where it should reside based on the information that is known about the company.
Supply and Demand
Supply and demand can take the short-term balance out of the stock market and present opportunities for investors who have the patience to see that balance restored. Investors who can anticipate abnormal supply or demand variations can also capitalize.
Price reflects all the information that is known about a company and their ability to make money in the future. As information about a company's prospects is made public, prices will change. Uncertainty of the future can bring added volatility while psychological factors can amplify the effect of new information. Finally, supply and demand considerations can cause fluctuations not motivated by new information. Understanding why prices change is essential to success in the stock market.