The Dynamics of Supply and Demand
The basic economic principles of any fluctuation in prices are those of supply and demand: When more people want to buy a stock , the price moves up; when more people want to sell a stock , the price falls. Such an example can be the events of October 1987, when the Dow Jones Industrial Average dropped by 22.6% in only one day – Black Monday. Market analysts believe that such an immense drop can be explained by an unexpectedly sharp inundation of sell orders that were not counterpoised with the due mass of buy orders.
At the same time, it is obvious that the above-mentioned market sentiment plays a crucial role in stock prices, backing the demand. Thus, when the company reports it has had a good quarter and the future looks like the industry will start booming, investors get such information and begin buying their stock. One of the examples of such an increase in demand, which happened in the case of Apple Inc., was the announcement in January 2020 that the company had big quarterly earnings. The demand for Apple’s stock arose immediately and pushed its price up for almost 10% within a few days.
Economic indicators also affect the stock prices by changing the expectations regarding the future growth or recession of the economy. As soon as, for instance, in December 2019, the U.S. unemployment rate fell to 3.5%, the lowest value for the recent fifty years, its stock prices rapidly rose in all other sectors. As stocks are considered the riskier investments among others, a strong economy also means that investors are ready to take risks.
Obviously, low-interest rates also contribute to rising stock prices. As they trigger lower gains for bonds and savings account purchases, investors prefer purchasing stocks with their potentially higher appreciation. For instance, during the rate cut by the Federal Reserve in March 2020, the stock market first fell due to panic concerning the spreading of COVID-19 but soon began to rise again as investors had a chance to purchase stocks at lower prices due to low borrowing costs.
Finally, stock prices are regularly influenced by political events, which determine the political stability of the state. For example, in June 2016, due to the Brexit referendum, the global stock prices dropped due to immense instability, triggered by investors’ fears to anticipate the potential consequences of the UK withdrawal from the European Union.
How Buying and Selling Pressures Move Stock Prices
For any investor, it is important to know how buying and selling pressures work because every time stock prices change, these forces are in action. This is a direct consequence of the way how markets work and how trades are executed: in short, when an investor decides to sell a stock, their order goes to the stock’s order book, which also includes buy orders. Many orders then become matched automatically, and depending on the balance between buy and sell orders, the stock’s price will move. Since the order book is a real-time list of buy and sell orders for a particular stock, organized by price, this will be reflected immediately on a stock exchange.
Market Makers
It is the responsibility of market makers that this system works properly. Market makers are companies that are always ready to buy or sell a particular stock: in other words, in the order book, there is always a buy order and a sell order for a stock. Without market makers, one side of the order book could be too thin, and the stock would become too volatile to trade. The important function of market makers is obvious in highly stressful financial events when governments sell all the U.S. Treasury bonds they have, and market makers still have to be ready for the next trade.
The Impact of Large Volume Trades
Large volume trades can have a very significant effect: when an institutional investor such as a bank decides to buy or sell a large volume, their trade can become the single biggest order in the order book. The other side of the order book will lose, respectively, and the price, therefore, will move. This is why, in 2008, when many banks and funds sold their stocks due to the crisis, stock markets dropped very quickly.
Other factors
Many alternatives on how prices can move away from the pure balance between buy and sell orders exist. Stocks can be driven upwards or downwards by people’s psychological factors: fear, which leads to selling and, then, a price drop, and greed, which causes buying and, then, a purchase. This cycle repeats and leads to obvious overpricing or underpricing. In 2020, for example, problems with the COVID-19 pandemic caused a market crash of the S&P 500 by more than 30% in March. However, both fear was short-lived and optimism soon led to a rapid recovery reaching new all-time highs.
The Market Reaction to an Imbalance in Supply and Demand
Stock prices reflect supply and demand dynamics. If either of these two underlying forces is out of balance, a stock will exhibit great up and down movement. Let’s take a look at positive catalysts.
Analyzing Supply Constraints
Stock prices tend to rise dramatically on supply constraints , or when there are fewer shares to purchase. A good example of this would be share buybacks or if a company decides to go private. When Dell announced in 2013 that it would become a private business, the turnaround of the shares happened because investors realized there would be fewer shares to go around.
Therefore, investors, with the anticipation they’ll get paid soon, scrambled to get a piece of the Dell laptop pie, so to speak. There are only a few Dell shareholders. As long as you maintain supply constraints and sufficient demand, prices will rise.
Demand Spikes
On the other side, stock prices rise due to dramatic demand for a specific stock, say if good news is released. An example of this would be Netflix and the good news it received when it reported a meteoric rise in subscriber growth in January this year. Over the last month, from $514 to $551, prices have increased by about 17 percent. Investors demanded to buy and capitalize on growth, thus, shares skyrocketed.
The Effects of Oversupply
Stock prices will plunge due to oversupply. If there are far more sellers, or far more people providing shares to sell, than there are people willing to purchase shares, this will occur.
Alternatively, if there are shocking quantities of stock—a secondary offering in conjunction with the excitement of another store or this is the time to sell—and there may not be enough demand to meet supply.
It’s for this purpose that the tech stock bubble in the early 2000s was so catastrophic in that place. Tech stocks were coming out of the woodworks, the internet developing, use was immense. Intro stage was not yet figured out: more people have been guessing. These stocks, difficult to sell on, started to fall.
Market Capitalization as a True Indicator of Company Value
Market cap or market capitalization defines shareholder value or the value of a company in the stock market. It is very widely used and accepted, but still, the debate goes on whether it is an effective measure. Market cap is calculated by multiplying the current stock price by the total number of outstanding shares. This product gives the total value of a company, or market capitalization. Also, given the market cap helps objectively understand the size of a company and see what value it holds.
How to Calculate Market Cap
Choose a company and get the current stock price and number of outstanding shares. The number of outstanding shares is the total number of shares each person or entity holds or owns. For example, if Company X’s current stock price is $50, and there are 1 million outstanding shares, then the market capitalization of Company X is $50 million. The better part of market cap is such straightforward interpretation that lets see in one number how big or small a company is. For instance, Apple in early 2021 was with more than $2 trillion cap – a vivid example of the biggest company in the world.
Market Cap and Company Size
Market cap often serves to classify companies into multiple types but mainly goes to 3 categories: small-cap, mid-cap, and large-cap. Each class has certain properties and their risk assessment. It is true to say that large-cap companies are more secure investments than small-cap enterprises. If the market cap of large-cap companies is over $10 billion, the market cap of small-caps is less than $2 billion. In this case, small-cap stocks provide a chance for rapid growth, but they are extremely risky. Accordingly, investors often use the market capitalization to tailor their investment strategy. For instance, after the dot-com bubble burst, Enron also went bust. It was not because of miscounting but because the company was not even profitable in a $70 billion market cap at its peak. The business model was not sustainable over the long-term, and the fraud of the company resulted in the company going out of the market.
Why Stock Prices Reflect More Than Just the Current Value
Stock prices are dynamic and multifaceted indicators that do not always reflect a company’s financial performance in the most direct way. On the one hand, they encompass investors’ expectations about businesses’ performance in the future and the broader economic condition; on the other, these prices are also driven by market sentiment and even rumors. Finally, institutional investors who make their choices on the basis of in-depth research and analysis can also affect prices significantly, even if their decisions are based on the same expectations.
Investors’ Expectations
One of the most important reasons why stock price is not necessarily an accurate reflection of a company’s value is the fact that people do not invest in a business when it has a current worth that looks attractive. Instead, they do so because they expect the value to change in the future. For example, Amazon has to be one of the most highly valued companies even though it provided no profit for many years. As a result, the only reason the company should have such high prices is the investors’ high expectations of it growing high profits shortly, which would exceed the current prices many times.
Market Sentiment
Another important factor influencing prices is the sentiment of the market driving these prices. Thus, although only a tiny group of businesses had to report a decrease in their earnings in late 2008, the predominant negative sentiment supported by constant pressure in the media, fear of terror attacks, and mere rumors caused all the stock markets to fall sharply . Similarly, the announcement by the U.S. Federal Reserve of an interest rate cut, intended to boost the economy and prevent a recession, has led to a sharp decrease at first on the news because the cut was caused by recent uncertainties about the coronavirus followed by a rise in prices, as most investors expect the cheaper money to drive the economy.
Institutional Investors
Lastly, institutional investors are the other actors who can influence stock prices to large extent because they hold larger amounts of capital to invest than individuals. Their choices can be based on other investors’ expectations, which is frequently the case in terms of pension and mutual funds, but can also be based on in-depth research and analysis of the markets and industries of the companies. For this reason, if a major fund announces their investment in a particular sector, other people will also invest in this sector in the expectations of the unfolding of the positive event that the fund may be basing their decisions on.
Reference List
Rothman, L. 2008. “Negative Sentiment Drives Market Lower.” Forbes . [Accessed February 29, 2020].
US Stock Prices. 2020. Web. [Accessed February 29, 2020].
Examples of Non-Earnings Related Indicators Affecting Stock Prices
Stock prices can be influenced by a variety of indicators that do not stem from a company’s current earnings. These non-earnings related indicators are often as powerful in shifting stock prices as financial metrics and usually include market sentiment, macroeconomic indicators, and geopolitical events among others.
Macroeconomic Indicators
Macroeconomic indicators like interest rates, inflation, and unemployment rates, among others can have a profound effect on stock prices. For instance, when the Federal Reserve manipulates interest rates, the stock market moves. Lower interest rates lead to cheaper borrowing and since debt is cheaper, companies which have ample room to grow will seize the opportunity to take new loans and invest, growing demand in the economy and increasing the share price. An example of a macroeconomic indicator that influences businesses directly is the commodities prices. If agriculture prices go up, food and agriculture companies’ performance is expected to improve.
Geopolitical Events
Geopolitical events have a significant role in influencing stock prices. Conflicts, elections, trade negotiations, deals, and international agreements can shift up or down the stock market when they create a risk or confidence among investors. One of the effects of the Brexit referendum, which took place in 2016 in the UK, was high volatility in the global stock markets. The uncertainty about future trade and economic policy led to stocks selling off.
Innovations
Innovations and technological advancements often influence stock prices dramatically. When Apple unveiled the iPhone in 2007 and released it later that year, it not only changed the world of phones but also enhanced Apple’s stock price, because there was a great future earning potential for the tech company’s smartphones.
Regulatory Changes
Policy can have an impact on an entire industry for instance when healthcare regulations change, pharmaceutical companies, insurance providers, and hospitals are all likely to be affected. A good example is the introduction of the Affordable Care Act or Obamacare, in which many companies are expected to see changes in profitability as a result of new insurance enrollment and coverage requirements
