A stock moves up or down in price because of investor sentiment. If investors believe a stock is worth more than its current price, it moves up. If they believe it's worth less, it moves down. This is not the same thing as saying a stock moves up or down because it's intrinsically worth more or less than the current price. The entire stock market is immediately responsive to what investors believe. These beliefs generally are formed more in response to investor emotion – how they feel about the stock price – than directly from an analysis of the stock's metrics –such as improved or declining earnings, the price-to-earnings ratio or earnings per share.
The Stock Market Is Cyclical
One of the most important things for any investor to know is that the stock market is profoundly and relentlessly cyclical. Relatively independent of the circumstances of the nearly 20,000 individual companies traded on U.S. exchanges and over-the-counter, the entire stock market swings from a bull market that begins slowly moving upward and then accelerating, leaving investors giddy and optimistic, to a bear market that performs similarly, but in the opposite direction, leaving investors depressed and pessimistic.
The Relation of Individual Stocks to the Market Cycle
Beyond this cyclical behavior, of course, individual stocks move up and down in value for a variety of reasons. The interaction of cyclical overall market behavior with the myriad individual circumstances that change the fortunes of individual companies makes predicting what will happen next – whether in the overall market or with respect to any individual stock – somewhere between extremely difficult to impossible. The best short description of the rise and fall of any individual stock over time is that it's a random walk.
What Gives a Stock Its Value?
One of the more interesting developments in stock market analysis over the past two to three decades is a decline among prominent economists in the belief that the market is fully rational – that by and large the price of every stock accurately represents its real value – the so-called "efficient market hypothesis." Increasingly, economists have come to see that the market isn't fully rational at all – that it's profoundly affected by what economists call "sentiment," meaning the various emotions investors bring to their stock purchases. Consequently, a revision of the earlier belief goes something like this: Every stock is worth what investors believe it's worth.
The Market Cycle and the Individual Investor
To see how investor emotions affect the market, consider Everyman, a typical investor. Begin by tracking Everyman's emotional state toward the end of a bear market. Research shows that at this point in the market cycle the average investor is profoundly pessimistic and risk-averse. If, during the downward slide of the bear market Everyman "got into cash," to limit losses, he's going to stay in cash, then slowly inch back into the market. At this point, because Everyman's losses in the bear market have left him demoralized and uncertain, his investment choices early in the bull market will be conservative: value funds purchases may predominate along with Dow stocks, the larger S&P 500 companies and a considerable percentage of cash.
But the average bull market lasts more than eight years, and the first couple of years are particularly profitable for investors. Sooner or later, Everyman will be fully back in the market again and, as time goes on, investing with increasing confidence and boldness.
In the late bull market phase, Everyman maximizes his growing profits by investing in specialized (and relatively volatile) small-cap stock funds, in leveraged funds that multiply both gains and losses and in individual glamour stocks. Until the late bull market collapses, he may have been buying stock on margin.
Predictably, as the market falls and continues falling, these bold investments are hit especially hard and irrational exuberance turns to despair and, finally, capitulation, at which point Everyman tries to salvage what's left of his shrunken capital by going into cash, thereby unwittingly locking in his losses as the cycle repeats.
How Investor Emotions Affect the Price of Individual Stocks
Within the greater market cycle, stocks move up and down individually as well, sometimes in sync with the market cycle but just as often not.
In one sense, a stock's metrics determine its price movement: as a company's success in the market becomes known – with the release of quarterly reports, for example, or because of a favorable news release – investors respond to the good news. The volume of buy orders increases and, in response to increased demand, the price moves up.
But, again, how investors feel about the stock determines the direction and extent of price change. Increased earnings don't move the stock; it's investors' emotional reaction to the news of that increase that does it.
Because investors are both emotional and fallible, sometimes they drive up the price farther than the metrics warrant. At other times, because a company does business in an unglamorous or out-of-favor business sector or for other reasons, investors don't respond to the improved metrics, creating a "value" stock, one that on the basis of an objective analysis of its metrics ought to be priced higher. Warren Buffett, the fabled Omaha investor, generally invests in these underpriced companies and has become a multi-billionaire by taking advantage of the disparity between how investors feel about a stock and its intrinsic value.
Stocks increase or decrease in price on the basis of what investors think the stock is worth, not directly because the company is doing well or in response to analyses of worth. If Jim Cramer of "Mad Money" pitches a stock on CNBC, that almost always immediately drives up the price more than the company's increased earnings, despite the fact that Cramer's predictions of stock price movement are often wrong.
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