Theories abound about ways to predict how the stock market will perform, from the victor of the Super Bowl to butter production in Bangladesh. When it comes to prognosticating the direction of stocks, the truth is, nobody has a crystal ball. In most cases if a company performs well, the market price of its stock will tend to rise over the long term. But there are plenty of factors that can hold the stock price back or even cause it to drop.
Supply and Demand
A stock's inherent value is the company's liquidation value divided by the number of outstanding shares. Inherent value aside, ultimately a stock is worth what an investor is willing to pay for it, and that is a factor of supply and demand. If more investors want to buy the stock than there are investors willing to sell, the market price of the stock goes up. If more investors want to sell their stock than there are investors who want to buy it, the market price drops. If a company is doing well, or at least if the investing community perceives it as doing well, it tends to create demand for the company's stock, driving the price up.
Stocks don't just trade on a company's performance. They trade on expectations, typically reflected in the company's price-earnings ratio, or P/E ratio. The P/E ratio is the current stock price divided by its earnings. When expectations are high, the stock commands a higher P/E ratio. If analysts project earnings of $1 per share but the company only produces $.75 per share, the stock price might drop, even though the company is turning a profit.
The stocks of companies that have a long history of profitable performance typically command a higher market price than the stocks of similar companies with historically poor performance. Past performance is never a guarantee of future results. Even blue chip companies that have a long history of paying regular quarterly dividends in good and bad times can stumble. The stock market is an unforgiving taskmaster for companies that don't perform.
Market prices of even well-run companies are subject to the whims of the market, and can be influenced in the short term by such factors as news reports, world events, political upheaval, changes in prevailing interest rates and international complications such as wars or embargoes that might have little to do with the company's financial performance. That said, the market tends to reward well-run companies over the long haul. According to the Securities and Exchange Commission investors who are willing to employ a buy-and-hold strategy over long periods of time, such as 15 years, are likely to earn positive returns.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.