When stock prices are falling, the question on most investors' minds is "when will it stop?" In the midst of a roaring bull market, investors are eventually forced to wonder how long it can last. Since trading began in lower Manhattan and in other major financial centers around the world, individuals have wondered about and attempted to analyze the factors that drive the stock market. What causes markets to move? While there is no one answer, there are factors that are known to have a positive or negative impact on the equity markets, both on a daily basis and over time.
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Supply and Demand
Daily stock market movements are largely based on the laws of supply and demand. This means that stock prices will tend to appreciate in value as demand perks up and the supply of stocks for sale decreases. Conversely, if demand for a particular issue is low and the supply or volume of stocks for sale in the marketplace is high, prices will tend to decline.
Consider the following analogy:
During the summer months, when drivers are on the road traveling in large quantities, gasoline inventories are quickly used up and therefore the price at the pump usually increases. On the other hand, when it's colder, drivers tend to stay home, and the demand for fuel goes down. In turn this usually leads to lower prices at the pump. This is very similar to how the stock works as a whole: when a lot of people are buying, prices go up. (For more, see Economic Basics: Demand And Supply.)
The Overall Health of the Economy/Interest Rates
During flush economic times, investors of all stripes (retail and institutional) generally have lots of money to invest. As they put their money to work by investing in individual issues or mutual funds, which often hold positions in dozens and sometimes even hundreds of issues, equity prices tend to rise. On the flip side, during a recession or a period of slow economic growth, investors will be more reluctant or even unable to commit investment dollars. This can lead to a decrease in demand for equities and, by extension, a decrease in stock prices.
An example of what can happen to equities when the economy slows can be found in an analysis of the period after the terrorist attacks in New York and Washington on September 11, 2001. In fact, within a few months after the attacks many firms, particularly in the financial sector, fired swaths of employees and, as a result, the economy began to slow. This translated into less investing; the stock market responded by trending lower for the first three quarters of 2002. (For related reading, see Terrorism's Effects On Wall Street.)
Interest rates and their direction can also have a dramatic impact on the economy and the stock market. Lower interest rates stimulate borrowing by investors, individuals and companies. This in turn can lead to economic expansion, an environment in which saving and investing is common. Also, because consumers may have more cash, they will tend to spend more at retail locations, which drives up corporate profits and, by extension, stock prices.
Conversely, as interest rates rise, individuals and companies tend to borrow and expand their businesses less. This can translate into less saving and investing. It may also put a damper on consumer spending and force corporate profits to decline or level off. When this happens, stocks tend to decline. (For more, see How Interest Rates Affect The Stock Market.)
Just like retail mom-and-pop type investors buy or sell stocks, so do large institutions, such as brokerage firms and mutual funds. Only they don't purchase or sell securities in small quantities - they move large blocks. The large volumes that these institutions trade can often have an effect on daily, weekly and even monthly trading activity and price action.
In other words, if a large firm, such as Fidelity (NYSE:FNF) were to purchase 500,000 shares of XYZ stock over a period of two trading days, the price of the shares could increase rapidly as the supply of stock available for sale is soaked up. Conversely, if Fidelity is looking to unload a similarly-sized position within the same period of time, this would put a tremendous number of shares into the market all at once. If there are not enough buyers, the stock's price will fall.
Large institutions will sometimes use computers and computer programs to help manage portfolio risk and execute orders. The good news is that they can be used successfully. The bad news, however, is that these programs can be used to fire off mass orders to buy or sell an individual security or group of securities in a short period of time; this can have a huge impact on trading.
In fact, some say that the crash of 1987 and the many large point drops that the U.S. stock market experienced throughout the 1990s and early 2000s have been caused, or at least exacerbated, by program trading. (To learn more about this phenomenon, read The Power Of Program Trades.)
If individuals and institutions are upbeat about the future prospects for the economy and the markets, they will often purchase stock and drive prices up. On the flip side, if individuals and institutions are bearish about the future, they may sell some of their stock holdings. This can create a self fulfilling prophecy - in the markets, wide-scale pessimism can drive down stock prices.
In fact, psychological issues can have a tremendous effect on the markets. They can lead to both irrational exuberance and stock market bubbles, or sell-offs and short-term corrections in equity prices. (For related reading, see our Behavioral Finance Tutorial.)
Effects of Commodity Prices
Commodity prices can have a positive or negative impact on the equity markets as well. When the price of oil goes up, the price of gasoline goes up, which means that fewer potential consumers will be on the road or shopping. Also, companies that ship their goods via truck or freighter will have to pay more for deliveries, which in turn may have an adverse impact on their margins.
For example, cotton is a large component in many of the things that we buy from clothes to furniture. If the price of cotton increases markedly, consumers will usually buy fewer of those items, which could drive profits (and stock prices) down for manufacturers who use cotton in their product.
Investors should keep commodity prices in mind because this is another factor that can impact stock prices. (For related reading, see Commodities That Move The Markets.)
There are a number of factors that can impact equities trading, including supply and demand, interest rates, institutional investors and programs, market sentiment and psychology and commodity prices. Investors should be aware of these factors before getting into the market, and certainly monitor them after they've made an investment.