When stock prices go up and down, as investors we seek answers. However, it is challenging to make observations, with surgical accuracy, on what drives price movements. Often even professionals are at a loss to explain what moves stock prices. So, as amateurs what can one do to understand why stock prices change?
Here are four drivers of stock prices that you might want to keep in mind:
Company specific issues: Stocks represent ownership of a business. The operations, growth and profitability (earnings) of a business fluctuate, based on management decisions, competitiveness of the business and financial strength of the company, i.e., the fundamentals of the business. Often it could be a company specific piece of news that drives the stock prices. For instance, when Bharti Airtel announced plans to merge with MTN its stock dropped. Similarly, when the deal fell through, its stock rose.
Industry specific issues: The performance of a business is sensitive to the industry within which it operates. The industry structure, profitability, competition and regulations all affect stock prices of the companies operating in that industry. Some businesses are hugely cyclical and unpredictable, like the airline business. Others are more stable and predictable, like the education business. Some industries are high growth, like the IT service industry in India. Others are low growth, like the manufacturing of cassette tape players. Sometimes, the regulator might change the economics of an industry which affects stock prices. For instance, when TRAI announced that is considering a change in the billing structure for mobile calls, the stock price of mobile operators fell.
Economic issues: Businesses and industry operate in the context of the overall economy. In a developing country like India, the economic policies laid out by the Government have a huge impact on the future direction of economy. Economic issues like fluctuations in currencies and interest rates, inflation, taxation policy, deficits among others affect stock prices. For instance, when the Indian Rupee strengthens, the earnings of export oriented companies fall in Rupee terms.
Speculation: This is the X factor. Ultimately, stock prices are determined by what us humans are willing to pay for stocks. Not only is this driven by the demand and supply of a stocks, but more importantly it is driven by our animal instincts of greed and fear that grip us when markets are going up or down. It can be argued that when the BSE got as high as 21,000+ it was driven by greed, and perhaps had overstretched the fundamentals. Similarly, when the market was as low as 8,000 last year, it was driven by fear, and perhaps had overreacted on the downside.
Unlike some business news channels that needlessly try to find an answer to every move in stock prices, we don't believe that its possible to always pinpoint what drives stock prices on any given day. However, if you use the above framework, you might at least be able to improve your understanding of what drives stock prices in general.
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