CMC Invest
20 February 2023
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Important: This article is for general guidance purposes only and should not be considered investment advice. If you are unsure about the suitability of an investment, please seek out advice. When you invest, your capital is at risk.
If you’re a long-term investor, paying attention to the minute details of how your portfolio is performing can be counterproductive. You’re more likely to make a rash decision and harm progress towards financial goals if you’re constantly fretting over how stocks are moving over the short term.
Nevertheless, it’s still valuable to understand what forces influence the price of stocks. This way, you’ll know what to expect from your portfolio when market news breaks. This can eliminate surprises, offer peace of mind and help you keep faith with your chosen long-term strategy.
Of course, understanding how a stock might move also helps when it comes to picking investments, so let’s examine some of the things worth looking out for…
Ultimately, the prices of stocks are determined by the same forces that control the costs of other goods – supply and demand.
Public companies only issue a set number of shares. When more people buy these – i.e., when demand for the stock is high – their prices rise. When investors are looking to sell, their prices fall.
There are a few factors that determine how investors will view any given stock. These, in turn, can influence the prices of shares.
Stock valuations tell you whether stocks are overpriced or under-priced relative to what’s happened in the past.
Let’s say you want to buy a new jumper just before Christmas. In December, it’s priced at £50. In your mind, that’s too much to pay for it. You know that in January, when the post-Christmas sales kick in, you’ll be able to pick it up for £30. That’s when you’ll buy your jumper. This isn’t dissimilar to how many investors look at stocks.
If you identify that a stock you own is overvalued, you could take it as a signal to sell off your positions. When you find an undervalued stock in your portfolio, you may want to accumulate some more shares.
Professional investors assess whether a stock is undervalued or overvalued by analysing what are known as its fundamentals. These are sets of metrics that reveal more about a company’s financial situation.
A popular such valuation metric is the price-to-earnings – or P/E – ratio. As the name suggests, the ratio is calculated by taking a stock’s price and dividing it by its annual earnings.
"P/E valuations are useful and can provide some perspective on how elevated or undervalued stock prices are."
Investors often expect a company to have a certain P/E ratio depending on what industry it’s in. If a firm’s P/E ratio is below this value, it may be undervalued, meaning there might be a buying opportunity. If it’s above it, it could be overvalued, meaning selling could become a consideration.
This valuation method, however, has become more complex since 2008 with very low interest rates persisting until 2022. P/E ratios have generally remained elevated since the Global Financial crisis – which in the past may have indicated stocks were overvalued. Yet, this period also saw plenty of very good times to be invested, including most of the time from 2010 to 2021. Past performance is, of course, no indication of future results.
That said, P/E valuations are still useful and can provide some perspective on how elevated or undervalued stock prices are.
Monetary policy refers to how governments and central banks manage the economy through money supply and interest rates.
From 2008 – in response to the global financial crisis – many central banks worldwide adopted quantitative easing, essentially injecting cash into the financial system and pushing interest rates lower.
Low interest rates and money being pushed into the financial system are generally good things for stocks. Because interest rates are also used to calculate predictions of companies’ future earnings, lower rates mean these calculations come out higher and stock outlooks can seem rosier.
Low interest rates also mean it’s easier to borrow funds at a low cost, helping businesses expand and support a healthy economy – and that’s good for the stock market as well.
There’s obviously a flip side to this. If the money supply shrinks and/or interest rates increase – as they started to do in 2022 – these generally have a negative effect on stock prices. Central banks may raise rates if they fear the price of goods – i.e., inflation – is getting out of control and needs to be stabilised. Higher rates incentivise people to save more and spend less.
As rates rise, the cost of borrowing for companies also goes up. If they already have debt, it becomes more expensive to pay it back. Higher interest rates will also be used in calculations of predicted earnings, which will turn out lower as a result.
If you’re bullish as an investor, you act believing prices will rise. If you’re a bearish investor, you think they’ll fall.
Market sentiment refers to how bullish and bearish investors are as a group. Anything extreme can signal it’s time to expect movement in your portfolio. It may also represent a good buying or selling opportunity.
"Market sentiment refers to how bullish and bearish investors are as a group about the stock market. Anything extreme can signal a good time to buy or sell."
If sentiment is overly high – relative to what has happened in the past – this could indicate the stock market is ready to decline. If it’s overly low, it might be due to rise.
Think about people around a swimming pool on a hot day. It makes sense that several people think having a cool dip is a good idea. As a result, the pool is crowded as everyone splashes about.
Over time, however, people will have cooled off sufficiently – or decided sharing the water with a bunch of strangers isn’t all it’s cracked up to be – and return to their sun loungers. Gradually, the pool will empty out until no one is swimming.
That’s kind of how market sentiment works. If most agree on the direction of the market, buying and selling stocks accordingly, then who is left to keep pushing it in that direction? Very few people. The price direction will generally reverse.
A popular tool is the CNN Fear & Greed index, which measures a total of seven sentiment indicators. A reading over 80 – and especially 90 – signals the market is getting euphoric and may be due for a correction. Readings below 20 – and especially below 15 – are generally bullish.
There are several factors outside a company’s direct control that may impact its share price.
Some of these are obvious – the overall economic environment, for example, or the current rate of inflation. Others are less so, like currency trends or even the demographics of investors buying stock.
The presence of these factors may turn market sentiment bullish or bearish. They may also impact company fundamentals, which in turn may determine how a stock’s price moves.
Significant news events often move stocks, particularly if the headlines involve positive or negative events for a public company.
The most obvious example of this is when companies release earnings. If firms report fundamentals that beat analysts’ expectations, then their stock often rises. If it’s the opposite and they fail to meet what’s expected, then stocks can fall.
One caveat is that earnings reports can sometimes contain information that investors react negatively to, even if the company in question out-performs.
Let’s say for example, that Company A beat analysts’ expectations when it came to earnings. Those earnings, however, were largely attributable to an arm of the business that is due to be shuttered in the next 12 months. Investors may be fearful that the profits aren’t repeatable and sell the stock, resulting in its price falling. It’s worth checking, therefore, the underlying reasons why companies have beaten or fallen short of expectations.
The stocks of large public companies trade all the time. It’s easy to buy or sell them. As a result, when news impacts one of these entities, the market often reflects this very quickly.
The stock of smaller companies, however, is often more illiquid. That means it may be sold at lower prices since there are fewer buyers looking to acquire shares. Once again, it comes down to supply and demand having a role in how a stock is priced.
In conclusion, if you see a sudden move in your portfolio, the first step you may wish to take is understanding what’s caused it. Over the long term, it’s likely a stock will move in price for any of the reasons listed above. Has the company just reported earnings? Has someone prominent described it as “overvalued”?
Understanding this removes a layer of mystery from investing and can help you remain focused on your financial goals and long-term plan.
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