What Drives The Stock Market?

Most investors know that over a long period of time the stocks that they own will either increase, or decrease, in value based on the success or failure of the underlying business. Most investors also know that in the short term there can be wild gyrations in stock prices that can lead to purchasing a stock above or below its fair value.

The combination of a predictable long term outlook for stocks and not being able to time short term gyrations makes being a long term investor much easier than a short term investor. But it also raises the question – what causes all of the short term moves in the first place? Why is it that in the next year or two Apple’s stock performance depends on how they do as a company, but in the next month or two Apple’s stock may rise or fall with almost no news at all?

As an investor it is important to understand the reasoning behind these short term movements. Afterall, if you understand what is driving short term movements, while keeping a focus on the longer term fundamentals, you can set yourself up to buy great companies at bargain prices. Below are a few key components to understanding short term market timing.

Geopolitical or Macroeconomic News

Outside of earnings season there are frequently times when there is not much news coming out about a specific company or sector, so investors tend to look for geopolitical or macroeconomic news to get a sense for news or events that may change the path of an industry. How much the market moves from geopolitical or macroeconomic news depends on the severity of the event and how it changes expectations for the future. While most economic news by itself is uneventful, there are occasionally times when big events will hit the wires that will move the entire stock market. For example, think about how little of an impact a single Jobless Claims report will have on the market versus an announcement that the US will be putting tariffs on Chinese goods. The Jobless Claims impact is usually minimal, but the tariff announcement moved the entire stock market and even commodities and bonds.

Earnings Reports

One of the most predictable market movements is during or around the release of earnings reports. Earnings reports are quarterly reports issued by all publicly traded companies that give an update on their financial well being, so it is easy to see why these might cause a stock price to move. In practice, it is not always about whether the company released earnings that went well though. A lot of the time the stock price movements are about the expectations of the earnings. For example, if Apple grew their Earnings Per Share (EPS) by $1.00 in one quarter you may think it is a great report, but what if analysts and Wall Street expected them to grow their EPS by $2.00? In this example you would likely see the stock price fall because they showed growth, but not quite what the analysts expected them to show.

When it comes to market moving earnings reports there are generally two things to remember.

  • In the short run earnings reports will generate volatility – this is good for short term traders
  • In the long run one single earnings report is likely insignificant to the true value of the company

Crowd Investing Mentality

When there is little news or earnings to impact the markets but prices are still rising it may be due to investors buying a stock or index for fear of missing the rally that is occuring. In doing this, investors tend to increase the amount of risk they are taking on by jumping into a market that may, or may not, have a fundamental reason for moving. In the end, this can create a scenario where stocks “melt up” or reach levels that are much higher than any fundamental would justify.

Likewise, when stock prices are falling, no one wants to stick their neck out and be the first one to buy for fear that it may not acutally be the bottom, so investors tend to stay on the sidelines. This occurs even as prices reach prices investors would have been happy buying at a short time before. In the end, this can create scenarios where stocks “melt down” and fall to rock bottom prices that are way lower than the fundamentals would justify.

Both of these scenarios are examples of herd mentality and show that not all market moves are tied to some news or fundamental event. To exploit these events you need to have a long enough time horizon, and the intuition, to notice when stocks may be overvalued or undervalued and act quickly to take positions.

Managing the Fluctuations

The best way to manage the everyday fluctuations in the market is to just put your head down, don’t get spooked by the daily dose of bearish news, and invest for the long term. Owning an individual stock means that you are part owner of that company, and the intrinsic value of a company doesn’t move very much in a small period of time, so forget about the day-to-day news and focus on the longer term.

Think of owning a stock like owning a home (but a very liquid version). There will be some short term fluctuations in value based on micro real estate trends, but over a long period of time you expect your home to appreciate in value. The same is true with well run companies. There are always short term fluctuations, but over a long period of time the company will grow and so will it’s stock price.

To be fair, that doesn’t mean that all short term movements in stocks are unwarranted, but it is usually easy to spot those that are. For example, if it was announced the city was planning to build a jail right next to your house that would materially impact the long term value of that property. The same is true for stocks. The trade war with China was a great

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