Even if we ask ourselves why do stock prices change, the only thing certain about the stock market is that stock prices will go up and down. One day, your share of Apple (AAPL) stock may be up $10. The next day, it may be down $5. In simplified terms, stock prices fluctuate daily due to the supply and demand in the market. However, there are many underlying factors that drive the changes in the supply and demand for stocks. In this article, we’ll take a deeper dive into what makes a stock go up and which factors affect stock prices.
Supply and Demand
While there are many factors that affect the prices of stocks, ultimately, it boils down to supply and demand. When there are more buyers than sellers willing to pay for a stock at its current market price, they will drive the price up. When there are more sellers than buyers, they will push the price down.
To determine the current market price, we look at the bid-ask spread. The bid is the price buyers are willing to buy at while the ask is the price sellers are willing to sell at. The difference is the spread and in order for a trade to take place, the buyers and sellers will need to come to an agreement on a price. Investors’ expectations of what a company’s shares are worth will drive their rationale in terms of determining this price.
Example of Supply and Demand
Let’s say the current market price of Tesla is $600.
There are 10 buyers waiting to purchase shares of Tesla at $590 per share.
There are 5 sellers willing to sell shares of Tesla at $610 per share.
4 new buyers enter the market and are willing to pay the $610 price.
These 4 new buyers then purchase shares for $610, thus driving the market price up to $610. Meanwhile, the 10 buyers who set their price to $590 will not be able to buy shares at the moment because there are other buyers willing to pay more.
This shows how investor demand can cause stock prices to go up.
While investor demand is what drives stock prices up, most buyers must see value in a company to be willing to invest in them. One way to determine how a stock should be valued is to look at fundamental factors such as a company’s earnings and profitability.
Earnings Per Share (EPS)
Earnings per share is a type of earnings base that is used to measure how profitable a company is. It is determined by dividing a company’s net profit by the number of outstanding common shares.
Companies with a high EPS are valued more because this indicates that investors believe the companies’ profits are higher relative to their share prices, thus are willing to pay higher prices for shares. Using this metric, investors can gauge how much others in the market are willing to pay for each dollar a company earns.
Price to Earnings Ratio (P/E ratio)
A price-to-earnings ratio is a valuation multiple that is used to determine a company’s value. It is calculated by dividing a company’s current market price by its earnings per share.
If a company has a high P/E ratio, that could mean 2 things: either the company is overvalued or investors believe the company will have high growth rates in the future. Currently, there are two types of P/E ratios that are used – forward P/E and trailing P/E. The forward P/E relies on future earnings guidance, or what the future earnings of a company are expected to look like. On the other hand, the trailing P/E relies on past performance and is calculated by dividing a company’s current share price by the total ESP earnings over the past year. There are drawbacks to both metrics, but the P/E ratio is one of the most used tools for deriving a stock’s valuation.
Technical factors are external conditions that can affect the supply and demand of stocks, such as inflation, trends, and economic growth.
Based on past data, low inflation has an inverse correlation with companies’ valuations. This means that when there is low inflation, that will drive higher multiples or higher expectations of future growth, whereas when there is high inflation, that will drive lower multiples. While small increases in inflation will generally not affect the stock market, a rapid rise in inflation can negatively impact the stock market as investors panic and pull their money out in anticipation of a crash. On the other hand, deflation, which is the decline in price levels, is generally bad news for the stock market because that means companies have less control over pricing power.
Economic Strength of the Market and Peers
Usually, a company’s stock price tends to follow the general trend of the market and their sector or industry peers. Some leading investment firms believe that a large part of a stock’s movement is determined by how the overall market and sector is moving rather than how the company is performing individually.
Investment research indicates that economic and market factors account for 90 percent of a stock’s movement. An example is the recent drop in tech stocks. Last year, many tech companies saw more than 100 percent increases in their valuations, but this year, the momentum in tech stocks has collapsed mostly due to fear of inflation, leading to widespread selloffs across the sector.
Companies are constantly competing for investment dollars. Investors have many financial options to choose from, such as bonds, real estate, commodities, and cryptocurrencies. If the performance of the stock market is trailing other assets, then investors may be more inclined to put their money elsewhere.
Recently, I started diversifying my investments from stocks to other assets such as cryptocurrency because I was not getting the returns I wanted from the stock market. After seeing many of the stocks in my portfolio get continuously beaten down, I decided to look into other financial options to park my money. While a majority of my investments are still in the stock market, I realized that I needed to find other options to spread my risks.
Incidental transactions are stock trades that occur for reasons other than the belief in a stock’s intrinsic value. Such transactions can occur when executive insiders make a pre-scheduled transaction or make changes to meet their portfolio objectives. They can also happen when an institution buys or shorts a stock to use it as a hedge, or a way to limit risks, for another investment. While this type of transaction may not affect investor sentiment, it does affect supply and demand, which then impacts the stock price.
Demographics play a large role in the demand for stocks. Investment research indicates that middle-age investors are more likely to invest in the stock market as they reach peak earning potential in their careers whereas older investors remain invested, but are more conservative and gradually sell off their stocks for retirement.
The chart above by Tradimo News hypothesizes that as you grow older, your income grows and you start owning more, which makes you more likely to invest in the stock market. As Baby Boomers age, they remain invested in the stock market, but the demand for stocks will rise as Millennials start to make more money and invest. This combination then leads to high stock market returns in the long term.
Since the pandemic, there has also been a rise in young investors who are now beating Wall Street at its own game. They focus more on communicating through social media, following retail trends, and finding companies that align with their beliefs rather than traditional concepts like balance sheets and P/E ratios.
As a member of Gen Z, I spend a lot of time trying to understand the thought processes of other retailer investors and the motivations behind their investments and trades. While I do conduct my own due diligence to identify the underlying value of the stocks I invest in, I also factor in market sentiment, trends, and my perception of them. For example, I am a huge fan of renewable energy and EVs, so I do not invest in any oil or gas companies. As Millennials and Gen Z grow older and start to make more money, it will be interesting to see how the market changes and adapts to us in the future.
Sometimes short-term trends like the recent Gamestop frenzy can push up the price of a stock through momentum and popularity. As the price of the stock rises, more investors buy in to make a profit which pushes the price up even more. The opposite of this can also occur, which is known as reverting to the mean. Since trends can swing the stock prices up or down, they are not a good predictor for the future and are more likely to have a short-term impact.
Liquidity is an important factor that can drive changes in a stock’s price. Investors are more likely to pay attention to highly liquid stocks as they tend to be large-cap companies that have a strong following. As a result, they are more responsive to current news, investor sentiment, and other events. Small-cap companies tend to be less liquid because there is less attention on them, which also means that they are more likely to be traded at a discounted price.
Market sentiment refers to how investors feel towards an individual stock or the stock market as a whole. It measures investors’ attitudes and mood, but can also be described as the public opinions, outlook, or view of investors collectively. Investor psychology heavily influences market behaviors and drives supply and demand. When investors are bullish, or confident about the market, they can push the stock market up. When investors are bearish, or pessimistic about the market, they can drive the price down.
This topic is being explored through a new field known as behavioral finance, however market sentiment is often very subjective and biased. For example, negative press can push the price of a stock down even if nothing has fundamentally changed about the company’s finances and operations.
Investors also tend to feel more pain when their portfolio goes down than feel joy when their portfolio is up. This could make them more likely to sell when they see their stocks falling due to the psychological effects of watching their stocks fall. Much of market sentiment is not based on fundamental factors, but on how investors individually and collectively react. However, it can be a good way to understand overall market behavior when used in combination with other factors.
The Bottom Line
There are many factors that can affect stock price and different types of investors rely on different indicators to make their investing decisions. Some factors only affect prices in the short term while others may affect prices in the long term. As an investor, it is important to remember all the key factors and take them into consideration. That way, you can better understand how key factors can impact individual stocks as well as the entire stock market and use that to stay in control of your financial future.