Bonus Material:
There are many factors that determine share prices. Many of these factors are ignored by private investors and so they miss out on moves. Share prices often move for specific reasons and if you know what affects share prices early then traders can make handsome profits.
This article goes through various factors that have effects on stock prices and how you can take advantage of them.
How are stock prices determined?
Stock prices are determined by several factors:
- Company specific factors
- Economic and political factors
- Market sentiment
Company specific factors
Company specific factors determine the share price of the company.
If a company is trading well or in an earnings upgrade cycle, then the stock price can trend upwards.
If the company is trading poorly and has already warned on profits, then it can be expected that the stock is trending downwards. We’ll look at this more in detail later.
Economic and political factors
Economic factors will always play into share prices.
For example, the lockdown policy in the United Kingdom hit the share prices of airlines, retail, and hospitality businesses hard.
Economic decisions such as the budget and general elections all affect share prices.
When the Conservative government won the election in December 2019, stock prices across the board rose because this government has a reputation for pro-business and the opposition would’ve brought in controls on business policies.
Here’s a chart showing the FTSE 100 on the announcement of the election result.
Market sentiment
Finally, overall market sentiment can affect share prices.
P/E ratio (or price-to-earnings ratio) is a good measure of investors’ sentiments across the board.
This ratio shows how much the market is willing to pay for the company’s earnings.
A company with earnings of 2p per share and a share price of 10p would be on a PE ratio of 5. But if the market sentiment towards the stock rose and the share price rose to 20p then the market would be paying a multiple of 10 for the same earnings!
Stocks can be cheap for several reasons but if market sentiment changes then these reasons may not matter anymore.
In the Dotcom bubble, market sentiment was rampant and the market didn’t care about profits. All a company had to do was say something about the internet and its profits would surge.
Here is an example of extreme euphoria.
“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”
Scott McNealy, Business Week, 2002
A company can have the same unchanged earnings per share (EPS) yet sentiment rerates the company to a higher earnings multiple.
A bull market sees stock market prices trade on lofty multiples and a bear market will see bad news heavily affect stocks.
Who controls the share price?
No single person or entity is often able to control the share price.
Stock prices change on supply and demand.
If there is more demand than supply then prices will rise. And if supply outstrips demand then prices will fall.
It doesn’t matter how many buyers or sellers there are – only the number of total buyers and sellers.
For example, if the share price is 140p and there is one buyer buying 50,000 shares up to 150p and several sellers below 150p with a total of 20,000 shares, then the price will rise to 150p because the total number of shares being bought outweighs the number of total shares being sold.
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How do share prices work?
The stock market is open between certain times and only during these periods can trades be dealt.
The London Stock Exchange is open from 08:00 until 16:30 and during this period shares can be bought and sold.
During this period, people buy and sell for many reasons.
Technical traders will buy on technical factors looking at past price movements and long-term investors will look at the future cash flows of a company.
The market capitalisation of a stock can also have an effect on the price movement of a stock.
If liquidity is thin then any sudden buying or selling can move the stock quickly due to a restriction in supply and demand of the stock.
What affects share prices?
Supply and demand factors that affect share prices include company news, economic and industry factors, as well as market sentiment and the weather. Demand pushes share prices up and when there are more sellers than buyers this affects share prices negatively.
Company news
Company news is the most important factor that affects share prices. If the company is performing well then the share price will perform well too over time.
However, even if the company is only thought to be performing well, this can boost the company as anticipation is factored into the price.
Here’s a chart from Westminster Group (WSG), which saw a big gap up in the price on the announcement of a 20 year managed services contract.
Economic and industry factors
Economic and industry factors matter. If people are fearful of a recession this can mean they hold back on expansionary projects and growth, and reduce their headcount.
Advertising is typically held back and so marketing companies can see hits to their share prices. However, supermarkets are often resilient because no matter how bad a recession people will still do their weekly shop (even if they are more cautious on spend).
In the Coronavirus pandemic in 2020, companies that supplied PPE and testing kits saw their share prices soar whilst travel and leisure companies were hit savagely.
Here’s a chart from Restaurant Group during the lockdown period (arrow where I opened my short).
I shorted this stock aggressively because it was clear that the company would be in big trouble. Plus, the market was running scared and any falls in stock prices were causing panic.
I tweeted this on 12 March 2020.
Thankfully, Wagamama did survive. I still enjoy the grilled duck donburi from time to time.
The weather
You might laugh but the weather does indeed affect stock prices.
What happens in an extended heatwave? Garden DIY and outdoors furniture gets snapped up. Hospitality sees a boost due to people enjoying the weather for longer.
Natural disasters also can affect prices. In the Icelandic volcano eruption planes were grounded for days. This affects airline profits and earnings and so share prices respond accordingly.
It’s worth paying attention to weather trends as anything out of the ordinary have affect specific sectors and companies.
Common reasons why share prices fall
The main reasons why share prices fall are profit warnings.
Profit warnings are when the company announces to the market that profits will be lower than what the market previously expected.
The share price reaction depends on the severity of the profit warning.
Other reasons include:
- Institutional investors dumping stock into the market
- Large shareholders receiving margin calls and closing out positions
- A change in industry regulation for the worse
- Falling commodity prices
- Terrorist attacks and cyber hacks can affect company profits
Common reasons why share prices rise
The big reason for share price rises is due to ahead of consensus earnings profit surprises leading to earnings upgrades.
Brokers tend to be too conservative on their current earnings projection estimates. This is because if they put earnings too high and the company misses then they look bad.
But if the company beats their expectations they can say that they were more right than they thought!
The effect here is that the future value of a company has increased with a strengthening earnings report, and so this in turn sees buyers scramble for stock.
Earnings seasons are a great time to trade because there are often many surprises which provide lots of volatility in public companies.
Other reasons can include:
- Institutional or other investors mopping up loose stock
- Industry tailwinds
- Fundamental factors improving, for example a new product
- Rising commodity prices
- Suspected mergers between two companies or a takeover
What affects the stock market the most?
The stock market in general is affected by many factors.
The big fear at the time of writing this article is inflation. Why?
Because inflation means the cost of capital increases, meaning investments become higher risk.
If interest rates are low then borrowing money is cheap. This encourages spending and economic transactions and therefore economic growth.
But with higher interest rates that means borrowing money is expensive, and lending money also increases in value.
If you can achieve a high return on your cash from interest in the bank then this reduces the appetite for investments.
Government bonds are known as the ‘risk-free rate’, and the higher the risk-free rate the higher the returns investments have to make to beat this rate.
When interest rates rise, this can affect the stock market negatively.
The goal of central banks is to manage this balance between spending and interest rates.
For clues on how stocks will react, pay attention to interest rates.
Managing stock market fluctuations
The best way to manage stock market fluctuations is to know what you own and why you own it.
There will always be different factors as a reason to sell but if you are thorough in your research you can hold your positions with conviction.
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