3 Factors That Trigger Substantial Fluctuations in the Stock Market

   Stock prices are set in the market where the amount sellers offer meets the demand from buyers. One may wonder about the forces driving stock market prices. Sadly, there is no exact formula that explains how stock prices move. 

However, clear patterns do show factors that drive these prices up or down. These factors are grouped into three main categories: fundamental factors, technical factors, and market sentiment.

Fundamental Factors

Fundamental factors are crucial in setting stock prices within an effective market system. The basic elements are described in brief below.

1.An earnings base, shown by numbers like earnings per share (EPS),

2.A valuation multiple is represented by ratios such as the price-to-earnings (P/E) ratio.

When investors buy common stock, they are essentially buying a part of the company’s profits. Earnings per share (EPS) represent how much investment return shareholders get.

 Thus, the valuation multiple, like the P/E ratio, shows what investors are ready to pay for future expected earnings. Some of the profit might be given out as dividends, and the rest is often put back into the company.

The potential profits depend on both current earnings and how much these earnings are expected to grow.

Earnings per share, or EPS, often show a company’s profitability. However, other measures like free cash flow per share might give a better picture of its earnings strength. Different sectors use unique metrics to assess their financial successes. 

For example, real estate investment trusts, or REITs, use funds from from operations (FFO), and mature companies often focus on dividends per share for evaluation.

The valuation multiple reflects what the market expects a company to achieve in the future. This value mostly depends on the present value of future earnings, which is estimated by discounting important factors such as:

1.Expected earnings growth rate

2.The discount rate is applied to forecast future earnings’ present value.

Generally, a higher expected growth rate leads to a higher valuation multiple, while a high discount rate might lower it. On the other hand, a lower discount rate means a higher multiplier. 

The discount rate can change based on the risk of inflation (or interest rates). Stocks that are seen as riskier usually have higher discount rates, which translates into lower multiples. 

Consequently, when inflation rates go up, discount rates also increase, which reduces the current worth of future earnings during times of rising prices.

Technical Factors

Technical factors affect how much demand there is for a company’s stock and its supply, making the process of setting stock prices more complicated than just considering basic elements. Some of the major technical factors are explained in brief below.

1.Inflation: Inflation has a significant effect on stock prices beyond its influence on valuation multiples. 

Generally, lower inflation is associated with higher valuation multiples, whereas deflation often means companies have less pricing power, which negatively impacts their stock prices.

2.Economic Strength of Market and Peers: Stock movements are generally aligned with the performance of the broader market and similar companies in their industry. 

Movements in the market or sector typically drive stock behavior more than how an individual company itself is doing, heavily relying on economic conditions.

3.Substitutes: Companies compete with other types of investments around the world, like bonds, commodities, real estate, and foreign stocks, for investment dollars. 

The availability and attractiveness of these alternatives can influence a company’s stock performance.

4.Incidental Transactions: Certain transactions, such as those by company insiders or institutional investors, can affect stock supply and demand, which influences stock prices. These transactions occur, although they do not represent direct approval or disapproval of the stock’s value.

5.Demographics: The age and earning ability of investors, especially those who are middle-aged, have a significant influence on stock demand and valuation rates. 

Because middle-aged people often earn more, they are likely to invest more in stocks, which pushes up demand and increases the value multiples.

6.Trends: Stock prices often follow short-term trends where increasing stocks tend to attract more interest while declining ones may lose value. 

However, forecasting these trends can be difficult because their patterns are unpredictable.

7.Liquidity: A high level of liquidity indicates strong investor interest in a particular stock and greatly affects its price reactions. 

Large-cap stocks are popular and have many buyers and sellers, which makes them highly liquid. Alternatively, small-cap stocks typically have fewer transactions, potentially lowering their value.

8.News: Investor attitudes and stock prices can quickly change with news updates or unexpected events involving companies, industries, or the global economy. Political changes, new products, or company mergers often drive these shifts.

Market Sentiment

Market sentiment plays a crucial role in determining stock prices. It captures the overall attitude of investors, both individually and as a group. However, working with market sentiment can be tricky due to its subjective nature.

Often, investors might trust in the growth potential of a stock, but unexpected news can cause quick and significant price changes that aren’t based on the stock’s fundamentals.

Behavioral finance, a relatively new concept, investigates the psychological and social influences on investor behavior. 

This field suggests that markets are not always efficient because human emotions can lead to poor decision-making. Behavioral finance supports several observable patterns where human biases steer market movements and trading actions.

These include trends like herd behavior, where investors follow each other without rational basis for their decisions, or loss aversion, where they fear losses more than they value equivalent gains. 

These biases reveal why sometimes markets behave irrationally, contradicting traditional models that assume all participants act purely out of self-interest with complete information.

Conclusion

It is imperative that stock traders recognize the various factors that influence the prices of stocks. Short-term investors value technical aspects, whereas long-term investors concentrate on fundamentals. 

Those who focus on fundamentals argue that while technical factors and market feelings affect short-term changes, the underlying basics determine long-term value. Behavioral finance investigates market behaviors that don't fit with conventional theories.