What factors move the stock market? What about individual stocks? How do interest rates affect the stock market and what does this have to do with the Consumer price index and inflation?
Many people know that economic factors such as corporate profits and interest rates tend to influence the movement of the broader stock market. However, I found it particularly interesting to actually analyse how these factors move the market and whether one should follow such trends when purchasing individual stocks.
Corporate profits and GDP
A drop in the Gross domestic product (GDP), the market begins to fear a recession and a subsequent drop in corporate profits. With worsening economic conditions, the market may enter a recession resulting in reduced demand for many company’s products.
Following on from this, many company’s earnings will be affected and the corresponding company stock price will fall (rationale outlined below). Thus, when the GDP and corporate profits fall, the market will suffer.
Interest rates, the CPI and inflation
There are two ways that interest rates can affect the movement of the stock market and it is important to understand the relationship between the consumer price index (CPI), inflation and interest rates to understand this.
Typically, when the CPI increases, the market fears inflation and this triggers interest rates to rise. Companies with debt will be forced to pay higher interest rates on existing debt, thereby reducing earnings (and earnings per share). This is the first reason that a rising CPI and interest rates will cause the market to fall.
Secondly, since inflation fears cause interest rates to rise, higher rates will make non stock market investments more appealing for the average investor. Why would an investor purchase a stock that may only earn 8 percent (and carries greater risk), when lower risk government bonds offer similar yields with less risk?
These inflation fears are known as capital allocations in the market (whether investors are putting money into stocks vs. bonds), and can substantially influence stock and bond prices. The market will usually redistribute investments from stocks to low-risk bonds when the economy experiences a slowdown and vice versa when the opposite occurs.
Should I follow the market?
An understanding of these factors is important but ultimately following this trend may not always be the ideal approach for the savvy investor. There are a multitude of opportunities to purchase undervalued companies during a slowdown in the market and as long as good company valuation analysis is completed, these times will provide some of the most profitable opportunities to purchase stock.
What moves individual stocks?
The only predominant factors that influence individual stock prices are earnings per share (EPS) and all things relating to rumours or speculation that may predict earnings per share. No other measure even compares to earnings per share (EPS) when it comes to an individual stock’s price.
Each quarter, public companies must report their EPS figures, and stockholders await the information in order to compare the actual EPS figure with the EPS estimates set by market research analysts. As an example, if a company reports $1.00 EPS for a quarter, but the market had anticipated EPS of $1.20, then the stock price will dramatically fall in the market the next trading day. On the flip side, if a company beats its estimates, its stock price will typically rally in the markets the next trading day.
There have been deviations from the principle of EPS being the central focus of stock price variation in markets over time. An example of this is where during the internet stock frenzy in the late 90’s and early 2000’s, investors believed that companies could operate at a loss for a year or two (low to nonexistent EPS) in the hopes of achieving substantial long term earnings as a result.
This is obviously an appropriate approach if you happen to have found the next Google or if you are committed to the company for the long term. However, if you are interested in short term profits or capital gains, the market is likely to move against you if you use anything other than the short term expected EPS of a company. This was evidenced by the market correction in 2001 where technology stocks drastically fell as a result of low to nonexistent earnings.
For a look into the benefits of an economic recession, click here.