3 Reasons Why Stocks Move By Jason Ng At Isnare.com Ezine Articles

For years, I have been asked this same question over and over again, “Why does stocks move?”.

For most people, the reason why stocks move has been a mystery. In fact, there are people who believed that someone is controlling these movements behind the scene playing against them! There are even people who believe that stocks move mainly due to good fundamentals. Well, look at it this way, if there is this big institution playing against you and taking all your money away from you, why aren’t all the financial institutions making money year after year? Why are so many funds closed down every year? If stocks move just because the business fundamentals are good and that the business makes sense, then why do good stocks fall at all?

The truth is this; stocks do not move based on what is happening in the world right now but based on expectations of future events! These expectations create a temporary imbalance in the number of buyers and sellers, moving prices. When there are more buyers and fewer sellers, sellers will hold off selling until prices have been bid up higher. When there are more sellers than buyers, sellers will continuously lower their asking price in order to entice buyers to pick up their stocks. Those dynamics create the ups and downs in the stock market.

What do “expectations” in the stock market really mean? To put it simply, you would avoid driving along a road that is expected to be congested, right? You wouldn’t go all the way down the road and see the congestion before deciding what to do, will you? That is the same decision making dynamic in the stock markets. The real issue here is what kind of expectations drives that temporary imbalance in the number of buyers and sellers which moves stock prices? That brings us to the 3 reasons why stock prices move at all.

Reason 1: Earnings Expectation

Have you ever wondered why a lot of stocks actually fall after releasing good earnings? Well, that’s because along with every earnings release comes earnings guidance! Earnings guidance is the estimated earnings for the following quarter. If the next quarter is guided lower and the stock is expected to fall when the time comes, wouldn’t you start selling today while prices are still high? That’s the same theory behind the congested road scenario mentioned above. Similarly, if earnings guidance is great, the stock continues to move higher. This is what the stock market call “pricing in” the future earnings.

Reason 2: Dividends Expectation

Dividends are an extremely important reason to own stocks. For stocks that never pay a dividend, this is not really a concern but for stocks which have been paying a steady dividend, changes in the expected dividends yield can cast doubts on the future profitability of the company, thus resulting in a sell off today. Similarly, if expectations of future dividends are raised, future profitability of the company can be expected to be better, resulting in a rally today.

Reason 3: How Much Investor Are Willing To Pay For Those Earnings & Dividends

Yes, now that you know that earnings expectations and dividends expectations creates the conditions by which stock prices might change, the only question which remains is how much would such a change be? Just as you might wish to pay a different price for your burger down the street under different economic conditions, the amount of money investors are willing to pay for future earnings and dividends also differ under different economic conditions. When the economy is looking upbeat and everyone’s optimistic, you might be willing to pay a higher price for the same expected future earnings. Conversely, when the economy is looking sour and everyone’s pessimistic, you might want to pay a lower price for that same earnings outlook. All these are reflected in what the stock market call “multiples” or the full name being “Price Earnings Multiples” or “PE ratio”. The PE ratio tells you how many times above earnings is the current stock price and represents the amount of money investors are willing to pay for that earnings outlook. Under good economic conditions, investors may be willing to pay up to 100 times earnings while bad economic conditions may justify only a 50 times earnings.

When times are good and higher prices are justified for the same earnings, the stock market is in a period of “Multiples Expansion”. Conversely, when times are bad and lower prices are warranted for those same earnings, we call it a period of “Multiples Contraction”. Understanding which period the stock market is in will result in tremendous profitability trading stock options which can profit both ways.

These 3 factors interact in the minds of traders and investors all the time. Sometimes when earnings guidance is higher for the next quarter in a poor economic condition, stock prices might still fall as investors may be willing to pay only a much lesser price for that earnings. So, next time you try to make sense of why stocks are moving the way they are, think in terms of these 3 factors and you will definitely see the light.

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