Have you often wondered what causes stock prices to rise and fall? The emotional roller-coaster that results from a 2-point gain one day only to lose it the next can be more than some investors to bear.
However, most of the changes in a stock’s price can be easily understood with what you are going to discover in this article. In fact, not only can you understand why stock prices rise and fall but you will also discover how to use this information to get bargains on good stocks and take profits on your successful investments at the best times.
Below, we will examine why the prices of stocks rise and fall over the short term and long term. We will look at these one at a time as the reasons behind these movements are very different depending on the length of the stock price change.
Causes Influencing the Price of Stocks Over the Short Term
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 buy it or put it up for sale.
What causes these day to day, week to week, and even month to month variations in the price of stocks? The primary answer is supply and demand; eager sellers drive prices down, whereas eager buyers drive prices up. However, what drives people to buy and sell?
Since there are so many factors which influence the desire to buy and sell (which in turn cause the price of stocks to rise and fall), it is easier to break it down into two categories: price changes due to catalysts and all other price changes.
Short Term Stock Price Changes in Response to Catalysts
A catalyst simply refers to an observable event or thing that makes people want to buy or sell a stock. These catalysts can influence whether or not people want to buy or sell both individual stocks or stocks in general.
Catalysts which make people want to buy or sell stocks across the board may have a noticeable short term effect but typically result in long-term changes in the price of a stock or commodity, so they will be considered in the long term section of this article. Here we will look at factors which influence individual stocks.
Catalysts that Cause a Stock’s Price to Rise
Better than expected earnings. When a stock outperforms analyst estimates, it tends to see its price rise. However, take “beating earnings” with a grain of salt: beating analyst estimates by a few cents is typical of most companies because it looks good when a stock beats estimates, even if it is only by a marginal amount.
This means that stocks not only need to beat estimates but need to demolish them in order to see nice boost in their stock price. Sometimes companies issue guidance that they are going to beat analyst estimates. In this case the stock price may have moved earlier and may not react to big earnings. It is only the true and significant surprises that cause a stock to pump upwards.
New products. When a company announces a new product or an anticipated product’s release date, it can move the price of a stock up. For example, the first iPhone was a big deal for Apple. At the same time, new products may be questioned by analysts and may not benefit the stock’s price if the products are not perceived to be profitable.
The reason that these surprise new product announcements will raise a stock’s price is due to the fact that these new products may bring in extra income for the company. A new product announcement may lead to higher than expected profits which leads to a price hike. Early-acting investors may assume that new products may increase profits and will act accordingly by buying stock, hoping that the stock will run even higher once the company realizes those potential profits off of its new product line.
Expected product upgrades do not have this same effect. To continue with the Apple example, future iPhone and iPad announcements really have to “wow” investors and produce higher than expected sales in order for the stock price of AAPL to move noticeably as people are already accustomed to these new generations of products. Analysts already know people will buy the next iPad or iPhone so announcing a new model is not a game-changer (and hence not a stock-mover).
Broker upgrades. When a major brokerage gets behind a stock or upgrades it, this can move the price up. While you should never buy a stock based on this alone, money managers and mutual fund managers who work at these firms may include a stock in their funds should higher ups at these firms issue solid guidance. Since money managers control a lot of the capital in the stock market, a broker upgrade at a major firm can drive a stock price up significantly in a short time.
Bad News for Competitors. Imagine a scenario where Wal-Mart suddenly declared bankruptcy overnight. Rather than bad business conditions, imagine that a few executives engaged in faulty accounting practices and secretly extorted billions of dollars from the company, causing it to fold. What do you think would happen to the stock of a competing retailers like Target? It would go up, of course, as Target would stand to benefit from Wal-Mart’s imaginary misfortune in this example.
However, these moves are often slight compared to the amount the bad news will affect the company on the receiving end of the bad news. Wal-Mart shares in this hypothetical scenario could easily fall by 50% or more, whereas Target shares would not rise by nearly that amount.
Also note that bad news for competitors only benefits a stock if the bad news for the competitor is unrelated to changing business conditions. An example of this is department stores. The woes at J.C. Penney and Sears are not necessarily going to benefit more successful competitors like Macy’s, because the trouble at the former stores is related to less people shopping at malls and department stores in general. Customers are choosing different means of consumption (i.e. eCommerce) rather than going directly to the competitors.
One example of this principle in action was the myriad of Johnson & Johnson recalls in the 2010 era. Johnson and Johnson recalls hurt JNJ but did not mean people were going to stop buying essentials like Tylenol. This caused the sales and earnings of makers of generic drugs to go up and hence the stock prices of these generic drug makers to go up as well. People who anticipate rallies like this can cause short term bumps for the stock price of the benefiting company.
Bid for Acquisition. Perhaps no other factor can cause a stock’s price to jump like a suitor looking to buy a company. Good companies with battered stocks that get bought out can provide huge boosts to a stock’s price. If the deal goes through, stock holders are often compensated at a premium.
New Regulations/Laws. Should a new regulation or law end up improving the bottom line of a company, the stock can react favorably. Looking at our retailers again, if Congress ever passes a bill which implements online sales tax, local retailers of all sorts will see increases in stock price as consumers will inevitably curtail online shopping on high ticket items if they can get them for cheaper in a store.
For example, you can buy high priced electronics on Amazon at prices which typically do not vary from major retailers, but buying them online means you pay no sales tax in most states. Should laws change this, local retailers will see an increase in prices.
Catalysts that Cause a Stock’s Price to Fall
Earnings Miss. An earnings miss is devastating for a company’s stock price. As mentioned, many analysts try to set the expectation so a company beats it buy a cent or two. If a company manages to miss in spite of this, it is very bad. You often see stocks beat earnings without gains, but you rarely see stocks miss earnings without at least a few point drop.
Losing products. This is most common in the consumer products and pharmacy industry, where expiring patents and generics can cause a company to lose exclusive rights to a product. Many brand name medicines can generate billions of revenue, so losing products like this can cause a stock’s price to move down.
Broker Downgrades. When a major broker downgrades a stock and it loses institutional support and its fund managers sell off the stock, a stock’s price can drop.
Good News for Competitors. When something good happens to a company’s competitor, the former company can actually lose share price. Imagine if two companies in the same sector were bidding on a massive contract Dow 30 company. Both stocks will rise in anticipation. Whichever stock wins this contract will remain up whereas the loser may drop.
This is seen frequently in the pharmaceutical space, as different drug companies are often developing new drugs to treat the same conditions. When one company has the “best” drug to treat a particular condition, it can charge quite a bit of money for this particular medication. When a competitor develops a similar drug that is either cheaper or more effective, the former company’s stock price may suffer when that new drug from the competitor gets FDA approval.
Note that good news for competitors can also cause a stock’s price to rise when the competition for earnings is not direct. For example, if two companies (company “A” and company “B”) are competitors that report earnings two weeks apart. Imagine company “A” reports first and reports an excellent quarter without a particular catalyst (i.e. a new groundbreaking product or a major contract), investors may assume that business is simply favorable in a particular space and assume that the company “B” will report a good quarter as well. Investors think that if consumers are buying more than expected of what company “A” has to offer, they will probably buy more than expected of what company “B” has to offer as well.
This latter example happens frequently in the restaurant industry. If one large restaurant chain reports particularly poorly or particularly well, investors think that other restaurant stocks will often report similar results, as the assumption is that poor results are caused by less people eating out than expected whereas good results are due to more people dining out than expected. It is not an entirely accurate assumption, but investors (and hence stocks) trade on it nonetheless.
Failed Acquisitions. Setting up acquisitions is expensive. If a deal does not get approved, billions of dollars can be wasted and the stock will suffer. For example, AT&T suffered at the hands of a failed T-Mobile merger.
New Regulations/Laws. New laws and regulations can cripple companies. In our example above, what do you think will happen to Amazon’s bottom line if sales tax on online purchases was implemented nationally? It would be disastrous for the company and its stock price.
Lawsuits. Lawsuits are never good for a company’s stock price. Examples would be getting sued over patent rights and product licensing. However, the most damaging lawsuits tend to be health-related (tobacco companies paying out for creating cancer causing products, for example).
Management Changes. When a company’s CEO or CFO suddenly leaves, stock prices can tank and rightfully so. A sudden departure usually means something bad was discovered (i.e. fraud) which will be announced to unwitting stock holders shortly.
When companies fire a CEO for poor performance, it is done gracefully, not suddenly. The reason is no CEO will want to work for a company which just threw their last CEO out with no warning. As a result, stock prices fall in response to sudden management changes and for good reason.
Other Situations that Cause Stock Prices to Rise and Fall
Sometimes, stock prices rise and fall, even dramatically without a major catalyst. Here are some of the reasons why this may occur.
The Actions of Big Players. When hedge fund managers and other investors or money managers with very large amounts of capital move into or out of a position, they can single-handedly move a stock up or down a few points depending on how fast they move and the size of the company in question. Naturally small stocks will move more than large stocks.
This is visible in both bad stocks when big money settles a short. After a prolonged decrease in stock price, a sudden hike in price can indicate a major short seller is taking their profits. This hike in price can be dramatic, unprecedented, and be short lasting. Many beginning investors mistake this for being a turn around in a stock but it is nothing more than a big shorter settling up.
Pullbacks, Corrections, Consolidation Periods. Pullbacks, corrections, and consolidation periods are very common in the stock market and are natural occurrences with little impact on the long term price of a stock.
A pullback occurs after an individual stock’s price has unnaturally inflated beyond its numbers due to eager investors. This happens to great stocks and is nothing to worry about in the absence of a catalyst.
Pullbacks are common after a stock has a run of several good days or weeks and are to be expected when investing in any stock. When eager buyers drive up the price of a stock into a range where more people want to sell and take profits, a pullback is inevitable.
In fact, pullbacks are actually a great time to buy into the stocks of good companies. Do not buy into a stock when it is a vertical tear upwards – these prices will come down at some point in the next week or two, even if it is only for a day. Even great stocks have pullbacks, so be patient and get a good price.
A market correction is used to describe when the market as a whole suffers from a pullback. These are normal occurrences and can represent even a several percent drop of the market in a single day. Market corrections are okay because they happen after the stock has run up a bit and because they also make great buying opportunities.
A consolidation period is essentially a slow, drawn out pullback or sideways movement of a stock. Most stocks do not steadily increase over time but increase in response to good earnings news and then meander sideways or slightly down until the stock’s earnings catch up to the multiple that investors are willing to pay or until there is reason to believe that a stock’s price will increase.
For example, if a hot stock is growing at 10% per quarter, its price might increase 10% in response to an earnings announcement, then move sideways until the next earnings announcement a quarter later at which point it will shoot up again if the news is good.
This period of moving sideways is called the consolidation period. The take-home message here is you do not want to sell a great stock with good earnings during the consolidation period just because the stock appears stagnant. If you do that, you will miss the next run up in price. Be patient.
What you want to do is instead of committing more capital to your positions in good companies, wait for an individual stock to pull back or wait for a market correction to jump in and grab your stock at a great price. These happen all the time and it is a good way to find stocks on sale.
The trick to getting stocks cheap this way is to make sure that it is an actual pullback or correction and not the start of an ongoing downward trend. A stock which gets hit after one of the catalysts mentioned above is not feeling the affects of a pullback but is actually just lower in price due to bad events.
Stock Price Changes are Ultimately Due to Supply and Demand
The one factor all of these factors have in common is that they influence supply and demand. Positive catalysts will make investors reluctant to sell while increasing demand for shares from investors wanting to get in on the stock. This naturally decreases supply and increases demand, driving up stock price.
Supply and demand is what allows a “big player” seeking to take a large position to bump the stock price. If a new entrant takes on a very large position in a company, these purchases will temporarily decrease the supply of shares and drive up the price. Likewise, if a big player unloads a lot of shares at once, the stock could drop by a percentage point with no discernible basis.
As a side note, catalysts reduce a stock’s price without reducing the underlying company’s earnings power can be good opportunities to get a great company at a great price.
As a side note, catalysts reduce a stock’s price without reducing the underlying company’s earnings power can be good opportunities to get a great company at a great price.
Long Term Factors that Cause Stock Prices to Rise and Fall
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 quarter to quarter or even year to year.
While there are a lot less reasons why stocks move over the long term, some of these reasons are not understood by most investors. By learning and applying this information, 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 the company makes 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 the reasons listed in the previous section, over the long haul stock prices tend to stick to earnings.
However, 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 earnings growth is so important.
When a company not only increases earnings but increases them faster than they did in a prior point in time, it is a good sign that the company might be able to continue to do this and grow exponentially rather than linearly. Companies which not only create growth but accelerating growth sell for a premium for this reason.
Dividends. One of the primary reasons a company’s growing earnings influence the price of a stock is because large, profitable companies can pay investors dividends. These are typically paid out quarterly and are money straight into the investor’s pocket. Most investors choose to automatically reinvest these into their company (which is a good decision if the company is still strong).
However, dividends themselves often cause a stock’s price to center at a certain amount. For example, at the time of this writing, out of the biggest, steady companies with low volatility and high dividends pay out around 3-4% annually. If you track their stock price in the past, each stock typically maintains the same percentage yield from quarter to quarter.
As long as the company is healthy, the stock price rarely falls below this magic line as the income stream alone sets the price. If the company was to raise the dividend (which most good companies do over time), the stock price often elevates to match the new dividend.
For example, a steady earner like Johnson & Johnson might have a dividend which amounts to 50 cents, which (this is an example) may amount to a 3.6% annual yield (Share Price / (Quarterly Dividend * 4). If they raise the dividend next year to 55 cents, the stock price is likely going to automatically go up 10% so that the 3.6% annual yield stays the same. This is why people like companies with good earnings as they tend to pay good dividends (or may potentially pay a dividend in the case of fast growers).
Federal Reserve Interest Rates. When the Federal Reserve lowers interest rates, stock prices across the board tend to increase faster over time. When the Fed raises interest rates, the price of stocks of all sorts seems to decrease. This is because lower interest rates influence people to get loans for things like houses and influence businesses to borrow money to upgrade infrastructure and hire more employees to grow faster.
This means more sales for businesses, particularly those that are involved in supplying parts and machines to other businesses as well as companies which sell to builders. These industries are typically called cyclical stocks and their price rises slowly over time as the Federal Reserve lowers interest rates. Likewise, the price shrinks slowly over time as the Federal Reserve raises interest rates.
The reason these prices move is because when the interest rates drop, sales pick up for these cyclicals which translates to higher earnings and as we know higher earnings mean higher prices of stocks.
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. However, a lot of people do not know what the term “good economy” really means. Typically, 4-5% growth rate of the US’ economy and low unemployment signal a good economy.
Of course there are other factors which are important but these are the two primary indicators. Lower growth rates or falling growth rates and increasing unemployment numbers (or steady high unemployment) are signs of a bad economy.
When the economy is good, the price of all stocks across the board typically rises. This means that the P/E ratio is going to increase, regardless of earnings. This is because people have more money to invest and they assume companies will be able to grow their earnings faster in line with a faster growing economy as that is simply common sense.
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 companies, at least domestically. Booming economies in emerging markets have helped large American companies continue to grow in spite of the stagnant American economy from 2008-2011.
One exception to this rule is companies which produce things people just cannot live without, such as food and basic health supplies. Companies which produce pharmaceuticals, food, and necessary consumer products (diapers, toilet paper, and so on) tend to have steady prices even as the economy slows. This is because people cannot cut out expenditures on necessary goods when they have less money but rather cut things they do not need from their budget.
International Events. Negative events around the world can cause the prices of stocks to shake, particularly if the sector stands to be negatively impacted by the impending catastrophe. For example, the financial crisis in Europe in 2011 negatively affected our 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 price. 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 which need oil to do business less valuable.
Investor Sentiments. At the end of the day, if people do not like the stock market and there is not a high demand for the stocks of even good companies, the price of stocks will trend downwards.
For example, during the bear markets of 2008-2011, many companies continued to grow and increase earnings without getting commensurate increases in their stock price simply because investors were scared by sub prime mortgage meltdown of 2008.
However, when investor sentiment does finally turn around and people start liking stocks again, stock prices will often rally up, quickly. After many great companies posted continued earnings growth in late 2011 and early 2012, the market roared back and at the time of this writing the S&P 500 is already up 8.32% year to date.
What Causes Stock Prices to Rise and Fall Conclusion
Stock prices can rise and fall for a myriad of reasons. When looking at short-term changes in a stock’s price, you need to recognize if the price is the result of a catalyst or just day to day fluctuations 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) the stock, even at a loss.
On the other hand, if a catalyst reduces a stock’s price and has no influence on a great company’s earnings or future growth, consider buying at the lower price to get a good deal.
Prices change in the long-term primarily in response to earnings and earnings growth of a particular stock. Stock prices also shift over the long-term based on the Federal Reserve’s actions and the overall state of the economy as these things influence the earnings of companies over the long term. Ignore changes in the Fed and the economy at your own peril.