Understanding the basics of stock is a prerequisite to being a good investor. Wouldn’t you love to be a business owner without ever having to show up at work? Imagine if you could sit back, take a holiday in Manhattan, watch your company grow, and collect the dividends (a form of remuneration) as the money rolls in! This situation might sound like a pipe-dream, but it’s closer to reality than you might think. As you have probably guessed, we are talking about owning stocks.
This excellent category of financial instruments is, without reservation, one of the greatest tools ever created for building wealth. Stocks are a part, if not the cornerstone, of nearly any investment portfolio. When you start on your road to financial freedom, you need to have a solid understanding of stocks.
Today, we will focus on long-term influences that lead to a rise or fall of stock prices.
Stock Price Movements
Stock price variations over the short-term are incredibly frustrating for investors, particularly when the stock you bought drops a few points right after you purchase. Further to this, investors also become worried when they make little gains or losses in the long-term.
It has always been stipulated that changes in stock prices are primarily caused by demand and supply; thus, eager sellers drive prices down, whereas eager buyers drive prices up. Despite this phenomenon, there are other well-known specific attributes that impact changes in prices of stocks. These factors can be labelled as catalysts, and investors must therefore watch out for such catalysts which could boost their investments or diminish their funds.
Catalysts that Cause Changes in Stock Prices
A catalyst simply refers to an observable event or thing that makes people want to buy or sell a stock. These catalysts can influence prices of stock whether or not people want to buy or sell those stocks.
Catalysts which make people want to buy or sell stocks across the board may have an obvious short-term effect, but usually result in long-term changes in the price of stocks. Long-term catalysts that stimulate the price of stocks will be discussed in this piece of writing.
Now that you know why stock prices move up and down on a day to day and week to week basis, we will now look at the reasons why stocks move up and down in the long-term, such as on year to year basis.
While there are a lot less reasons why stocks move over the long-term, some of those reasons are not understood by most investors. By learning and applying the information below, you can gain an edge in predicting how the markets will fare over the next few years.
Earnings, Earnings Growth, and Future Earnings: The main driver of a stock’s price over the long-term is its earnings. The more money a company generates and the better margins it produces, the more money its stock is worth. While a stock’s price may rise and fall on a day to day basis without any change in earnings for various reasons, over the long-term stock prices are related to earnings.
Usually, stocks are priced based on their future earnings potential. The more potential investors think a stock has, the more they will pay for it now. This is why growth in earnings is important for a company.
When a company increases earnings faster than they have performed previously, it is a positive signal that the company has a high tendency to grow quickly.
Central Bank Interest Rates: When the central bank lowers interest rates, stock prices across the bourse tend to increase faster over time. When interest rates rises, the price of stocks seems to decrease. This is because lower interest rates influence people to get loans for investments such as houses; further, this also influences businesses to borrow money to upgrade infrastructure and hire more employees for growth and profitability.
When interest rates are high, Banks increase their lending rates – and this means people will borrow less and thus lead to a decrease in the amount of money consumers can spend. This will finally affect the topline (Revenue) and the bottom line (Earnings of companies), which will invariably lead to a fall in share prices.
The State of the Economy: Just like interest rates, the state of the economy has a broad, sweeping effect on the price of stocks in the long-term.
There are many factors that affect an economy, but the two important primary factors are lower growth rates and unemployment.
When the economy is good, the price of all stocks across the bourse typically rises. This means that the Price Earnings ratio will increase, regardless of earnings. This is because people who have more money to invest tend to assume that companies will be able to grow their earnings faster in line with a fast-growing economy.
The P/E of stocks will fall during slow economic growth and high unemployment. Higher unemployment means less money for consumers to spend, which means less earnings for companies.
Slow economic growth means less earnings growth and expansion opportunities for domestic companies.
One exception to this rule is companies that produce goods people cannot live without, such as food and basic health supplies. Companies which produce pharmaceuticals, food and necessary consumer products (example diapers, toilet-paper etc.) tend to have steady prices even when an economy slows. This is because people cannot cut-out expenditure on necessary goods when they have less money, but rather cut goods they do not need for survival from their budget.
International Events: Negative events around the world can affect the price of stocks, particularly if the sector stands to be negatively impacted by an impending catastrophe. For example, the financial crisis in Europe in 2011 negatively affected the stock market, particularly the financial sector.
The financial sector (i.e. banks) stood to lose the most in the event of a European meltdown, and as such lost the most in stock prices. However, each time a good news piece came out, such as a bailout of Greece, financial stocks tended to move upward in response.
Perhaps the most common theme that influences our stocks in modern times is tension in the Middle East. Since the Middle East produces a lot of oil, any talk of war between Iran and Israel makes crude oil prices go up. This makes companies which produce oil outside of the Middle East more valuable, and makes companies that need oil to do business less valuable.
Investor Sentiments: If investors do not like the stock market and there is a low demand for stocks of even good companies, the price of stocks will trend downward.
For example, sometimes during a bear-market many companies continue to grow and increase earnings without getting commensurate increases in their stock price, simply because investors are scared.
However, when investor sentiment become optimistic and demand for stocks starts going up, stock prices automatically begin to rally up quickly.
Stock prices can rise and fall for a countless reasons. When looking at short-term changes in a stock’s price, an investor needs to analyse if the price is the result of a catalyst or just a day to day fluctuation of trading.
If the catalyst represents a serious threat to a company’s bottom line, it may be prudent to sell (or at least reduce the position of) the stock, even at a loss.
On the other hand, if a catalyst reduces a stock’s price and has no influence on a company’s earnings or future growth, consider buying at the lower price to get a good deal.
Prices change in the long-term are primarily in response to earnings and earnings growth of a particular stock. Stock prices also shift over the long-term based on the central bank’s actions and overall state of the economy, as these things influence the earnings of companies over the long-term.
ABOUT OMEGA CAPITAL
Omega Capital Limited is an Investment management, private equity and investment advisory firm. The Company is authorised and regulated by the Securities and Exchange Commission of Ghana.
Kumapremereh Nketiah (JP)
Omega Capital Research
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Additional information is available upon request. Information has been obtained from sources believed to be reliable but Omega Capital Limited (“Omega Capital” or “The Firm”) does not warrant its completeness, accuracy or veracity. The firm is licenced and regulated by the Securities and Exchange Commission of Ghana (SEC). This material is for information purposes only and it is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and estimates herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information.