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FINANCIAL CHRONICLE™ » FINANCIAL CHRONICLE™ » Forces that move stock prices

Forces that move stock prices

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sriranga

sriranga
Co-Admin
When a company goes public through an initial public offering (IPO), an investment bank evaluates the company’s current and projected performance and health to determine the value of the IPO for the business.

The bank can do this by comparing the company with the IPO of another similar company or by calculating the net present value of the firm.

Once trading starts, share prices are largely determined by the forces of supply and demand. A company that demonstrates long-term earnings potential may attract more buyers, thereby enjoying an increase in share prices.

A company with a poor outlook, on the other hand, may attract more sellers than buyers, which can result in lower prices.

In general, prices rise during periods of increased demand - when there are more buyers than sellers. Prices fall during periods of increased supply - when there are more sellers than buyers.

A continuous rise in prices is known as an uptrend and a continuous drop in prices in called a downtrend. Sustained uptrends form a ‘bull’ market and sustained downtrends are called ‘bear’ markets.

Other factors can affect prices and cause sudden or temporary changes in price. Some examples of this include earnings reports, political events, financial reports and economic news.

Not all news or reports affect all securities. Stock prices can also be driven by what is known as herd instinct, which is the tendency for people to mimic the action of a larger group.

For example, as more and more people buy a stock, pushing the price higher and higher, other people will jump on board, assuming that all the other investors must be right (or that they know something not everyone else knows).

There may be no fundamental or technical support for the price increase, yet investors continue to buy because others are doing so and they are afraid of missing out.

Basics of bid-ask spread
You’ve probably heard the terms bid and ask before but you may not know what they mean or how they relate to the stock market.

The bid-ask spread can affect the price at which a purchase or sale is made - and an investor’s overall portfolio return. What this means is that if you want to dabble in the equities markets, you need to become familiar with this concept.

Stock exchanges are set up to assist brokers and other specialists in coordinating bid and ask prices.

The bid price is the amount that a buyer is willing to pay for a particular security. The ask price is the
amount that a seller wants for that security.

The difference between the bid and ask prices is what is called the bid-ask spread.

Supply and demand
Investors must first understand the concept of supply and demand before learning the ins and outs of the spread.

Supply refers to the volume or abundance of a particular item in the marketplace, such as the supply of stock for sale.

Demand refers to an individual’s willingness to pay a particular price for an item or stock.
The price of the stock is determined by supply and demand.

The more individual investors or companies that want to buy, the more bids there will be; more sellers results in more offers or asks.

On the Colombo Stock Exchange (CSE), the Automated Trading System (ATS) is designed to match buy and sell orders placed by the member firms (stockbroking firms) of the CSE.

Investors who have accounts with the Central Depository Systems (Pvt.) Ltd (CDS) place their orders with the brokers, either directly or through a custodian bank.

Orders are entered by the brokers through the ATS trading terminals, which are then transmitted online to the ATS.

The ATS trading terminals are located in the member firms’ offices.

The trading terminal performs three functions- display of market data, display of trader’s orders and executions and acceptance of new orders, amendments and cancellation of orders.

The ATS maintains an order book for each traded security, divided into bids and asks.

The prices are determined and orders executed according to specific rules detailed in the ATS rules of the CSE.

Stock’s bid-ask spread determinants
There are several factors that contribute to the difference between the bid and ask prices.

The most evident factor is a security’s liquidity. This refers to the volume or amount of stocks that are traded on a daily basis.

Some stocks are traded regularly, while others are only traded a few times a day. The stocks and indexes that have large trading volumes will have narrower bid-ask spreads than those that are infrequently traded.

When a stock has a low trading volume, it is considered illiquid because it is not easily converted to cash.

As a result, a broker will require more compensation for handling the transaction, accounting for the larger spread.

Another important aspect that affects the bid-ask spread is volatility. Volatility usually increases during periods of rapid market decline or advancement.

At these times, the bid-ask spread is much wider because market makers want to take advantage of - and profit from - the change.

When securities increase in value, investors are willing to pay more. When volatility is low and uncertainty and risk are at a minimum, the bid-ask spread is narrow.

A stock’s price also influences the bid-ask spread. If the price is low, the bid-ask spread will tend to be larger. The reason for this is linked to the idea of liquidity.

Most low-priced securities are either new or are small in size. Therefore, the number of these securities that can be traded is limited, making them less liquid.

The bid-ask spread can say a lot about a security and therefore, you should be aware of all the reasons that are contributing to the bid-ask spread of a security you are following.

Your investment strategy and the amount of risk that you are willing to take on may affect what bid-ask spread you find acceptable.

Forces that move stock prices
As mentioned above, stock prices are determined in the marketplace, where seller supply meets buyer demand. But unfortunately, there is no clean equation that tells us exactly how a stock price will behave.

That said we do know a few things about the forces that move a stock up or down. These forces fall into three categories: Fundamental factors, technical factors and market sentiment.

Fundamental factors
In an efficient market, stock prices would be determined primarily by fundamentals, which, at the basic level, refer to a combination of two things: 1) An earnings base (earrings per share (EPS), for example) and 2) A valuation multiple (a P/E ratio, for example).

An owner of a stock (ordinary shares) has a claim on earnings and earnings per share (EPS) is the owner’s return on his or her investment.

When you buy a stock, you are purchasing a proportional share of an entire future stream of earnings. That’s the reason for the valuation multiple: It is the price you are willing to pay for the future stream of earnings.

Part of these earnings may be distributed as dividends, while the remainder will be retained by the company (on your behalf) for reinvestment.

We can think of the future earnings stream as a function of both the current level of earnings and the expected growth in this earnings base.

(To be continued)

(Source: Investopedia and Automated Trading Rules of the Colombo Stock Exchange)
http://www.dailymirror.lk/business/features/27512-setting-of-stock-prices-and-forces-that-move-them.html

http://sharemarket-srilanka.blogspot.co.uk/

2Forces that move stock prices Empty Re: Forces that move stock prices Mon Apr 01, 2013 8:12 am

K.Haputantri

K.Haputantri
Co-Admin
Thanks Shri for sharing a valuble one.

3Forces that move stock prices Empty Forces that move stock prices Mon Apr 08, 2013 2:08 pm

sriranga

sriranga
Co-Admin
http://forum.srilankaequity.com/t27065-setting-of-stock-prices-and-forces-that-move-them?highlight=forces


Although we are using earnings per share (EPS), an accounting measure, to illustrate the concept of earnings base, there are other measures of earnings power. Many argue that cash flow-based measures are superior. For example, free cash flow per share is used as an alternative measure of earnings power.

The way earnings power is measured may also depend on the type of company being analysed. Many industries have their own tailored metrics. Relatively mature companies are often measured by dividends per share, which represents what the shareholder actually receives.

Valuation multiple
The valuation multiple expresses expectations about the future. It is fundamentally based on the discounted present value of the future earnings stream. Therefore, the two key factors here are 1) the expected growth in the earnings base and 2) the discount rate, which is used to calculate the present value of the future stream of earnings. A higher growth rate will earn the stock a higher multiple but a higher discount rate will earn a lower multiple.

What determines the discount rate? First, it is a function of perceived risk. A riskier stock earns a higher discount rate, which in turn earns a lower multiple. Second, it is a function of inflation (or interest rates, arguably). Higher inflation earns a higher discount rate, which earns a lower multiple (meaning the future earnings are worth less in inflationary environments).

In summary, the key fundamental factors are:
- The level of the earnings base (represented by measures such as EPS, cash flow per share, dividends per share)
- The expected growth in the earnings base
- The discount rate, which is itself a function of inflation
- The perceived risk of the stock

Technical factors
Things would be easier if only fundamental factors set stock prices. Technical factors are the mix of external conditions that alter the supply of and the demand for a company’s stock. Some of these indirectly affect fundamentals. (For example, economic growth indirectly contributes to earnings growth.) Technical factors include the following:

Inflation
We mentioned inflation as an input into the valuation multiple, but inflation is a huge driver from a technical perspective as well. Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples and high inflation drives low multiples). Deflation, on the other hand, is generally bad for stocks because it signifies a loss in pricing power for companies.

Economic strength of market and peers
Company stocks tend to track with the market and with their sector or industry peers. Some prominent investment firms argue that the combination of overall market and sector movements - as opposed to a company’s individual performance - determines a majority of a stock’s movement. (There has been research cited that suggests the economic/market factors account for 90 percent).

Substitutes
Companies compete for investment rupees with other asset classes on a global stage. These include corporate bonds, government bonds, real estate and foreign equities.

Incidental transactions
Incidental transactions are purchases or sales of a stock that are motivated by something other than belief in the intrinsic value of the stock. These transactions include executive insider transactions, which are often prescheduled or driven by portfolio objectives.
Another example is an institution buying or shorting a stock to hedge some other investment. Although these transactions may not represent official ‘votes cast’ for or against the stock, they do impact supply and demand and therefore, can move the price.

Demographics
Some important research has been done about the demographics of investors. Much of it concerns these two dynamics: 1) Middle-aged investors, who are peak earners that tend to invest in the stock market and 2) older investors, who tend to pull out of the market in order to meet the demands of retirement.
The hypothesis is that the greater the proportion of middle-aged investors among the investing population, the greater the demand for equities and the higher the valuation multiples.

Trends
Often a stock simply moves according to a short-term trend. On the one hand, a stock that moves up can gather momentum, as ‘success breeds success’ and popularity buoys the stock higher. On the other hand, a stock sometimes behaves the opposite way in a trend and does what is called reverting to the mean.
Unfortunately, because trends cut both ways and are more obvious in hindsight, knowing that stocks are ‘trendy’ does not help us predict the future. (Note: Trends could also be classified under market sentiment.)

Liquidity
Liquidity is an important and sometimes under-appreciated factor. It refers to how much investor interest and attention a specific stock has. Trading volume is not only a proxy for liquidity, but it is also a function of corporate communications (that is, the degree to which the company is getting attention from the investor community).
Large-cap stocks have high liquidity: They are well followed and heavily transacted. Many small-cap stocks suffer from an almost permanent ‘liquidity discount’ because they simply are not on investors’ radar screens.

Market sentiment
Market sentiment refers to the psychology of market participants, individually and collectively. This is perhaps the most vexing category because we know it matters critically, but we are only beginning to understand it.

Market sentiment is often subjective, biased and obstinate.

For example, you can make a solid judgment about a stock’s future growth prospects and the future may even confirm your projections, but in the meantime, the market may myopically dwell on a single piece of news that keeps the stock artificially high or low. And you can sometimes wait a long time in the hope that other investors will notice the fundamentals.

Market sentiment is being explored by the relatively new field of behavioural finance. It starts with the assumption that markets are apparently not efficient much of the time and this inefficiency can be explained by psychology and other social sciences.

The idea of applying social science to finance was fully legitimized when Daniel Kahneman, a psychologist, won the 2002 Nobel Memorial Prize in Economics. (He was the first psychologist to do so.)

Many of the ideas in behavioural finance confirm observable suspicions that investors tend to overemphasize data that come easily to mind; that many investors react with greater pain to losses than with pleasure to equivalent gains and investors tend to persist in a mistake.

Some investors claim to be able to capitalize on the theory of behavioural finance. For the majority, however, the field is new enough to serve as the ‘catch-all’ category, where everything we cannot explain is deposited.

Summary
Different types of investors depend on different factors. Short-term investors and traders tend to incorporate and may even prioritize technical factors. Long-term investors prioritize fundamentals and recognize that technical factors play an important role. Investors who believe strongly in fundamentals can reconcile themselves to technical forces with the following popular argument: Technical factors and market sentiment often overwhelm in the short run, but fundamentals will set the stock price in the long run.

In the meantime, we can expect more exciting developments in the area of behavioural finance since traditional financial theories cannot seem to explain everything that happens in the market.

Source: Investopedia and Automated Trading Rules of the Colombo Stock Exchange)
http://www.dailymirror.lk/business/features/27844-forces-that-move-stock-prices.html

http://sharemarket-srilanka.blogspot.co.uk/

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