The following is a guest post from Vincenzo Desroches. Vincenzo started a financial and forex trading site after years of self taught investment and has had an interest in economics virtually his entire life.
Stock Market speculation has produced thousands of millionaires in the 20th century. The historically unprecedented rise in the United States economy and equity markets during the last half of the 20th century increased the standard of living in America to levels generations past could not have conceived. This dramatic and steady rise in stocks and profit taking over the last 60 years has caused an investment truism to form—invest in the stock market over the long-term and you will see strong growth in your capital.
Although this truism of the last 50 years is now being questioned by the current global economic crisis, most long-term investors believe the market will continue to rise once America gets past its current troubles. The logic is simple. America has endured through every economic obstacle it faced over the last 50 years—why would this time be any different? Thus, in this article we will break down the very basic principles that cause stock prices to rise and fall.
In order to understand stock prices, we must first understand who sets a stock’s price. Human market participants are the ones setting a stock’s price by their buying and selling behaviors. Now, what do humans want in regards to stock market investing? Of course, they want money. And the easiest way to make money in stocks is to invest in companies that are making money.
As a basic rule of thumb, if a company is making money, its stock will increase. If a company is losing money, its stock will decrease. When a company has strong earnings, then its stock rises as well. Companies generally release a public announcement of company earnings every quarter. Prior to the announcement, Wall Street analysts predict how much the earnings report will be. If a company’s earnings beat market expectations, then its stock will tend to rise significantly. Conversely, if a company’s earnings fall below market expectations, then its stock price will tend to fall sharply.
Earnings are the primary driver of a stock over time. However, as we stated in the beginning of the article, a stock’s price is set by human market participants. Therefore, a company’s present earnings is not always the primary influencer of its current price. At times, and sometimes very often, a stock’s price will be set by market participants’ expectation of future earnings. For example, if a new company has lots of debt and poor management, but it has an incredibly powerful and innovative technology that is set to hit the market, then its stock price may explode based on the expectation of future earnings.
However, eventually things will balance out. If a stock is not able to support market expectations with true earnings, then the market will drive price down. There is a small sector of traders called “short-sellers” that actually specialize in finding companies that are overpriced due to fanatical market expectations. Once a short-seller finds such a company, he shorts the company’s stock in expectation that the true financial condition of the company will soon be highlighted and there will be a sharp drop in the stock’s price.
Thus, while stocks are primarily driven by earnings, it is very important to understand that stock prices are not always priced according to current earnings; instead, they are more often set according to market expectations for future earnings. Although a company may finally catch up with earnings and market participant projections, often these companies never fulfill the aggressive expectations set by investors. In fact, during the tech boom of the early 2000’s many companies and investors lost countless millions of dollars as companies’ stock prices got out of control and were based much more on hype and potential than actual real earnings. In the end, traders need to realize that while fundamentals certainly influence a stocks price, it is humans and their expectations that ultimately set the current price.
