In the purest of economic terms, the price of every individual stock is determined at the point where seller supply for that individual stock equals buyer demand. If more people want to buy a stock than want to sell, then excess demand will increase the price of the stock – and in theory vice versa.
But it isn’t as simple as that.
To understand the stock market fully requires some understanding of the forces that drive stock prices to move up or down. Broadly those forces almost always fall into one of four categories:
Fundamental factors drive stock prices based on the company’s earnings, profitability, distributions and retention of earnings after distributions or dividends have been paid.
In order to assess the impact of fundamental factors on a stock’s market price the Portfolio Manager performs Fundamental Analysis.
Fundamental analysis is an in-depth method of studying a target company’s financial statements and other external factors relating to the company in order to gauge the value of its stock. Fundamental analysis uses various ratios and statistical techniques to determine both the value of the stock and expected stock price movements.
Ratios used would include the price earnings ratio (PE Ratio), dividend yield, and return on equity (ROE).
Technical factors are a mixture of external factors that alter either the supply or demand for a company’s shares and so have an impact on the traded price of those shares.
When assessing technical factors, the Portfolio Manager performs technical analysis using historic data to predict future movements in share prices. In theory, if Portfolio Managers can gain an understanding of patterns in the past this will allow the Portfolio Manager to recognise those patterns should they appear again.
Technical factors the Portfolio Manager might assess would include the following:
Statistically individual stocks tend to track with the market and within their sector or amongst their peers. Some research has suggested that overall market and sector/peer factors account for over 90% of all movements in the price of individual stocks.
This means, for example, that factors that cause movement in the price of BP Plc stock and relate directly to the activities of BP Plc could also have an impact on the price of Royal Dutch Shell Plc and all other companies in the oil and gas sector.
There is a finite pool of investment dollars and so companies face competition for those investment dollars from other companies and other asset classes such as corporate bonds, government bonds, real estate, commodities, and non-domestic investments.
Incidental transactions are trading in stocks that are predicated or motivated by factors other than a belief in the fundamental factors (see above) or value of the stock. This would include an investor buying or shorting a stock in order to hedge another investment.
If you’re wondering what “shorting” is, the following example attempts to explain it:
If a broker wishes to short sell a stock, he opens a position by borrowing shares of stock that he considers are likely to decrease in value in a defined timeframe (before he has to return the borrowed shares).
The broker sells the shares as soon as he takes custody of them at the prevailing market price. Before the borrowed shares must be returned by the broker, the broker is betting that the market price of the shares will fall and that he can buy the shares to return them to the lender at a lower price.
Shorting stock – as in this example – is high risk because the loss the broker could incur is potentially unlimited as the market price of the stock could climb past the value he borrowed the shares at exposing the broker to substantial losses.
Historically low inflation has an inverse correlation with share valuations as low inflation drives high multiples and high inflation drives low multiples.
Therefore, deflation (a persistent fall in prices) is usually considered to be bad for stocks because it can signify a loss in purchasing power for the target company.
In terms of individual stocks liquidity is a vital factor. Liquidity refers to the interest a specific stock attracts. The more interest the more liquid the stock.
Generally, large stock caps have high liquidity meaning that they are highly followed and traded. Conversely, small stock caps suffer from a permanent “liquidity discount” because they are not highly followed or traded. Investors can find themselves “locked in” to a small cap stocks in the event that the price of the stock falls simply because there are few or no willing buyers.
If we concentrate on individual investors as opposed to institutional investors, we find that individual investors tend to fit into one of two camps.
First there are the middle-aged or professional investors who are peak earners with disposable income who have a desire to invest in the stock market.
Secondly, there are older investors who tend to pull out of the market at the point of retirement in order to dispose of their shares to fund retirement (usually through the purchase of an annuity).
Generally, the closer one gets to retirement the more conservative an investor tends to be in order to protect the potential funds available to purchase an annuity.
Trends can have an important impact on the short-term price of a stock. A stock that is climbing in price can gather momentum as effectively “success breeds success” or “failure breeds failure” and sentiment drives the stock higher or lower.
Assessing and predicting trends is perhaps one of the hardest investing hazards a Portfolio Manager has to navigate.
Note that the above listing of technical factors contained in this blog is not intended to be a definitive list.
Good and bad news can impact on the individual company, market sectors, markets as a whole, countries and globally as we have seen with the fall-out caused by a combination of low oil prices and the impact of the coronavirus and the responses to that pandemic.
Pandemics, political situations, negotiations between trade partners (witness the fractured trading relationship between the USA and China, or the likely future structure of the trading relationship between the UK and the European Union post BREXIT), new product development, acquisitions and mergers and unforeseen events (such as the Coronavirus Pandemic) can and do have a significant impact on stock prices and do impact on our final factor – market sentiment.
Market sentiment refers to the psychology of market participants both individually and collectively as a group (for the purposes of this blog entry assume ‘market participants’ includes, but is not restricted to, investors and potential investors).
Assessing market sentiment is notoriously difficult because market sentiment is subjective to individuals and by extension individuals acting together as groups. Indeed, some individuals by virtue of the size of their investments can have the same impact as a collective of smaller individual investors.
While Portfolio Managers may assess potential investments using sophisticated modelling tools and programmes and from the analysis performed may make a valid recommendation to purchase or dispose of a stock based upon technical factors as noted above, assessing and measuring ‘market sentiment” is notoriously difficult and can blow the Portfolio Managers recommendations clear out of the water.
Many Portfolio Managers have been left vexed when they have performed analysis, reached a supportable conclusion as to whether an investment should be purchased, retained or sold, to see the investment’s price held artificially high or low as a result of market sentiment.
Sometimes other investors see the same fundamentals as the Portfolio Manager, but this may take time and there is no guarantee that prices will adjust to reflect the Portfolio Managers technical assessment in a timely manner.
Next up: we will look at the impact of low oil prices and coronavirus on these markets and assess the likelihood of a quick recovery from what many have defined as the “perfect storm”.