Factors Affecting the Stock Market

The price of a stock is set in capital markets where selling pressure meets the demand from buyers. However, many people who have merely glanced into the world of finance still don’t understand the key factors that affect the stock market.

The fact remains that no specific model can accurately predict whether a stock’s price will go up or down. It is said that even the great American financier, JP Morgan, always said the market would fluctuate when asked if the stock market would experience a boom or bust.

Nevertheless, many people have made money from the stock market by making accurate predictions. These traders deeply understand the factors that drive the price of different stocks and use them to their advantage.

The market forces that affect the stock market include news about the market, fundamental, technical, and sentimental factors. Fundamental factors are divided into earnings base and valuation multiples. Technical factors include inflation, price trend, and demographics of investors.

Fundamental Factors That Affect Stocks

The two crucial fundamental factors that affect the live stock market are:

• An earnings base, like earnings per share (EPS).
• A valuation multiple, like a P/E ratio.

A person who owns common stock in a firm has a claim on the earnings made by that organization. Earnings per share represent the return on investment on the number of shares bought. Once you purchase a specific percentage of a company’s stock, it implies that you’re buying the same fraction of the firm’s future earnings.

While some of these earnings become retained earnings for capital reinvestment by the company, the rest gets paid out as dividends. Hence, when a company’s future earnings are being evaluated, both the current earnings level and the expected growth have to be considered.

The Earnings Base

Earnings per share (EPS) is a commonly used accounting measure to evaluate how a company is faring. This fundamental factor is, however, usually replaced or used in conjunction with other measures like free cash flow per share.

Depending on the company being analyzed, EPS may be discarded for other measures of earnings power. For instance, analysts evaluating a real estate investment trust use a measure like funds from operations (FFO).  

A company that has existed for a long period is typically measured by dividends per share. Dividend per share measures the return that a shareholder gets back for each share they hold in the company.

Valuation Multiple

The valuation multiple expresses the future earnings of the company. The crucial factors that affect the valuation multiple are:

• The expected growth in the earnings base.
• The discount rate, which gets the present value of the future earnings.

To summarize, an increased growth rate in the earnings base is seen as favorable and will get the stock a higher multiple. However, a higher discount rate is considered less favorable and will result in a lower multiple.

If a company earns $50 million in Year 1 and its earnings are projected to grow to $80 million in Year 2, this represents a higher return on investment. Thus, the valuation multiple becomes higher with the increase in the earnings base.

A discount rate gives the present value (what a future sum would be worth today) of future earnings. If you’re familiar with inflation, you should know that a sum of money like $1 million to be paid in 5 years would be worth more today. However, depending on the discount rate, inflation might negatively affect the lump sum.

For instance, $1 million to be received in 5 years could be discounted at a 5% rate. The result is $783,526, which means that what $783,000 can buy today will be purchased by $1 million in 5 years.

$1 million discounted at a 10% (a higher growth rate) in 5 years is $620,921. This means that what $620,000 can buy today will be purchased with $1 million in 5 years. Hence, this means that a higher growth rate is less valuable.

The discount rate is a function of the risk associated with the company’s stock and the estimated inflation rate. The higher the volatility of the stock’s price, the higher the discount rate. Also, the higher the inflation rate, the higher the discount rate. Higher volatility and discount rates both lead to lower multiples.

In essence, it means that if the company’s projected earnings will be worth less in the future, the valuation multiple will be lower. Fundamental factors were the first to be analyzed for stock market advice during the early days of the stock market.

Technical Factors that Affect Stocks

While fundamental factors closely examine a company’s financials, technical factors have more to do with the entire industry or economy. These factors also have a big impact on the supply and demand prices for a company’s stock.

Technical factors include:

• Inflation
• Economic strength
• Price of other financial instruments
• Demographics
• Trends
• Liquidity

Inflation

Inflation is an economic metric that a firm or industry cannot control. Even though inflation affects fundamental factors like the valuation multiple, it has an even bigger effect as a technical factor. Typically, inflation and valuation have a negative relationship.

In addition, the higher the inflation rate, the lower the valuation. Conversely, the lower the inflation rate, the higher the valuation.

Nevertheless, the deflationary factor could also lead to a drop in stock valuation. When deflation occurs in an economy, money loses its pricing power.

Price of Stocks in the Industry

The price of stocks sometimes follows that of other stocks in the same sector. Some hedge funds believe a company’s stock price depends more on the price of other companies’ stock in its industry than its performance.

For instance, in the trading session following the infamous 9/11 attacks, American Airlines’ stock dropped, and the rest of the aviation industry followed suit.

Price of Other Financial Instruments

When traders are looking to invest their money, they usually focus on a specific financial instrument. Hence, even though they might diversify their portfolios to include company bonds, cryptocurrency, commodities, and precious metals, the bulk of their money goes into the asset class they believe will perform best.

The price of stocks is greatly affected by the price movement of other financial securities. For instance, stocks and cryptocurrency have a positive price correlation. This means that as the price of crypto increases, stocks tend to increase. Some traders invest in both stocks and cryptocurrencies.

On the other hand, the stock market has a negative price relationship with the gold market. The higher the price of gold, the lower the price of equities.

Demographics of Retail Investors

The prominent demographic that affects the stock market is the age of most stock market investors. The idea is that middle-aged investors earn much money and are less likely to pull out their funds from the stock market.

On the other hand, if there’s a high percentage of old-aged investors, there’s a higher likelihood of the stock market experiencing a downturn. That’s because older investors typically cash out their capital gains to enjoy retirement.

Trend

The price trend of a company’s stock is another factor that can determine the stock’s price. If you look at a price chart of a company’s stock, you’ll mostly spot some significant upward and downward movements in the price.

That’s because a company’s stock’s short to medium-term movement largely depends on its price trend. When traders see that a stock’s price is increasing, they usually believe it will move higher in the short term, prompting a price surge.

If a company’s share price has been dropping for a specific period, investors could take it to mean that there’ll be a further price drop, sometimes triggering a sell-off.

News

Although no one can specifically state how much a news report will affect a company’s stock, it remains a big determinant of stock price. The political atmosphere, company mergers, and new technology are vents that can impact the stock market.

The world is a global village where retail investors and banks from several nations trade in other countries’ stocks. Hence, a news release from a company in another country could affect the stock price of a company or even the US stock market.

Market Sentiment

Market sentiment is largely based on the feelings of other investors toward a stock’s price. It is highly subjective and is often the most difficult to predict.

Even if a company’s fundamentals are great and the technical factors are alright, market sentiment could still lower a stock’s price. For instance, a negative news report that came out months ago could still keep the stock’s price low.

Conclusion

A stock’s price depends entirely on the supply of shares in the market and the corresponding buyer demand. The more demand outstrips supply, the higher the price of the stock. Conversely, the higher the number of sellers to buyers, the likelier the company’s stock price will drop.

Some factors influence the number of buyers and sellers of a company’s stock. They consist of fundamental, technical, and market sentiment factors.

Fundamental factors scrutinize a company’s financials to calculate earnings base and valuation multiples to predict a company’s stock price movement. Technical factors consist of factors outside the company’s control, like inflation, the price of other financial securities, and the demographics of investors.

Positive or negative news about a company could also affect the price of a company’s stock.

Have you invested in stocks before? Did it yield good returns? What were the challenges you encountered? Which of these factors do you think affects the stock market more?