Market Forces and Sentiment

What actually makes the market move?

The basics of economics and more importantly of market movements are dependent upon the company supply and the buyer demand. There is no real equation for this, or no standard ratio which can serve as a guide to the potential growth of a company but a company’s share price is determined by how supply of its products relates to their demand. We can view the movement of a company’s stock in three main ways which will help serve a better understanding of what is taking place in the bigger picture. These 3 areas can be classed as (1) fundamental and (2) technical factors plus (3) market sentiment.

Fundamental Factors

On the assumption that stock markets, particularly the one in which your potential company is listed, are Efficient, we would never need to look further than fundamental data. Fundamental data is the information we can gain about a particular company to establish its overall value and current share price. On the most basic level, the fundamental data is formed by two entities 1) the earnings of a company (Earnings per share or EPS) and 2) a valuation calculation of the company on the basis of these earnings ( Price/ Earnings or P/E Ratio). Note EPS and the P/E Ratio are probably the most used examples of gaining this fundamental data. There are other ways however but you will come across these more than any others when looking at certain websites or magazines talking about a company’s fundamental situation.

When you buy a share, you are basically buying a proportion of the company’s earnings. EPS will tell you how much you have technically earned per share. But not only are you buying into the company’s current earnings but a future continuous stream of earnings. This is where P/E comes into play. The P/E figure tells you how much you must pay in order to receive these future earnings. For example if a company’s P/E is 22, it means you have to pay 22 times the current amount of earnings in order to receive the same earnings in the future or in other words, you buy a share and wait 22 years before you get your initial investment back.

Unfortunately the earnings per share does not mean that you will necessarily receive that amount. The company may give you part of those earnings in the form of a dividend and retain the rest for reinvestment into the company. So it may take even longer than 22 years before you receive your initial investment. In share trading however there is a sense in which the P/E ratio tells a slightly bigger story, or at least it gives an indication of what other traders are thinking in relation to this stock. A low P/E is generally considered to be a risk. While it seems that it will not take long to earn back your investment in terms of dividend, the company is not expected to maintain growth and as such the P/E is low. A high P/E is generally expected to do well in the future and as such the earnings of the company are expected to grow creating higher EPS but also higher share prices. From my own perspective an enormous P/E, anything about 100 is usually a “Hot Tip” or a stock that is believed to grow double, triple or quadrulpe in a short space of time due to a new technology the company boasts or a new product that everybody the world over will want. Seldom is it realised. Personally, these stocks should be avoided but we will get onto that later.

There are a number of other ways the fundamental data of a company can be measured but EPS and P/E are the most commonly used and most commonly reported so unless you hold an accountancy degree you may wish to stick with these, at least until your knowledge grows.

Technical Factor

If only fundamentals were the basis for our understanding of a company’s real value, life would be a lot easier. Unfortunately like everything, companies sit in a much larger and complex world and like all things, companies have a number of strong external forces which for our purposes we call technical factors. Following is a general list of these factors:

Inflation– Reported regularly in the main media, inflation (or interest rates from a slightly different angle) is the single largest external factor affecting stock price. A high inflation will have the affect of pushing the P/E lower and as such making the stock more risky. A low inflation will have the adverse affect pushing the P/E of a company higher making the future earnings of a company more stable (beware the P/E also suggests if a company is overpriced, i.e. the company is not actually worth the share price it has). Deflation is a catastrophe as far as economics goes and restricts what price companies are able to sell their products at, providing little to no room for manoeuvre. High inflation is bad as less people can afford the company’s product as the product price increases and deflation is worse because company’s are forced to cut prices which in term makes losses which in turn means people lose jobs and it spirals on. You can see now why all central banks and economic theories in general on free efficient markets make inflation and controlling it the highest priority.

Economic Strength (Market and Peers) – Very generally speaking, companies follow a similar path to the wider market as a whole and more specifically the companies who are providing products in the same area. For example, in 2007 when the UK housing market fell significantly down, all house building companies suffered significant falls in their share prices. The wider economic strength of the housing scenario in Britain had a knock on effect on all house building and related companies. It does not always follow that companies follow each other but when a larger entity effects the market, they generally do the same thing. Also for example a company can produce poor results as it earned a lower than expected profit for the year. Other stocks that work in the same sector can also suffer due to “guilt by association”. One bad set of results for a company can suggest a bigger picture view of the sector and thus affect the share price of all companies in that sector. These bigger pictures are important, but when we get to method, we will put these things into context.

Substitutes – There are a number of different investment instruments (asset classes) available in the wider world market. These include: commodities, government bonds, corporate bonds, real estate, foreign equities in foreign stock markets to name a few. It is difficult to gage to relationship between these instruments and the general stock market but generally when one suffers, the other tends to do better. They should be taken into consideration, though like I said, it is difficult to ascertain the degree in which one profits more when another goes through a downward movement.

Incidental transactions – These occur when shares are bought or sold for anything other than the fundamental data determining the price of a stock. They can include company executives buying or selling their shares in the company for whatever reasons that may have been pre-scheduled for example. Hedge funds may be buying or shorting to hedge against other trades that they have made. These transactions, although not necessarily dependent upon the overall strength/weakness of a company, can have an impact on the share price.

Demographics – Here we are talking about the kind of people, namely based upon age, who are actively trading shares in a particular company. They are usually classed as 1) middle-aged peak earners who are actively trading (investing) in equities and 2) older investors who are pulling money out of the stock market for retirement purposes. The theory goes that the greater the number of middle-aged investors there are in the market, the greater the demand for shares and as such the higher the P/E (or whatever other calculation you may be using) will be.

Trends – Often associated with the following section (Market Sentiment), company share prices can experience “trending”, where a share can grow significantly as more investors “jump on the band wagon” and produce a steady upward trend. Often these trends tend to correct themselves and go back to the average or mean position, usually when traders sell their shares to make a profit. Trends work in both ways however and a steady downward trend through selling of the stock can be met with a sharp upward correction as the stock may have been over sold and thus under valued.

Liquidity – This refers primarily to the amount of money moving in and out of a particular stock. The larger companies around the world benefit from greater news coverage and general investor attention which makes them more invest-able than smaller companies. These larger companies are more heavily influenced however by fundamental news which in turn can affect the share price, sometimes significantly. Smaller companies do not receive such attention and as such may be out of range for many investors which in turn decreases the amount of potential investment they can achieve and as such ultimately liquidity. On the reverse bad news may not affect a smaller company in quite the way it does with a larger one.

The concluding part of this section can be found in Market Sentiment.