What Makes Stocks Go Up and Down?If we understand what moves stock prices, we can have a better idea of whether stocks will go up or down and when. Stocks tend to move as a whole. In other words, the up and down moves of most stocks is heavily tied to the overall stock markets. As such, let’s consider the overall stock market and what makes the stock market as a whole go up and down.
Stock Market EarningsInvestors buy stocks based on the earnings expected from that them. Investors are willing to pay a certain amount for those earnings, as measured by the PE ratio. Here’s the formula:
Stock Price Per Share/Earnings = PE RatioThe higher the PE ratio, the more an investor is paying for the stock. The PE ratio, then, has become a popular tool for predicting if stocks are more likely to go up or down. This is because stocks return to the historical average PE ratio by rising above it and then dropping below it. Since stocks return to the average PE ratio, it’s safe to say that it’s more likely that stocks as a whole will go up when the PE ratio is near historically low levels. On the other hand, it’s safe to say it’s more likely stocks will decline if PE ratios are near historically high levels.
Stock Market Earnings and The EconomyThe stock market as a whole tends to go up when the companies in the stock market make more money. The timing is usually off a little with this phenomenon, however, meaning that investors buy or sell stocks based on anticipated earnings, not just actual earnings. This makes it harder to know if stocks will go up or down in the near term because the future is less certain than the present. Most companies, however, naturally make more money when the economy is growing. This is because people have jobs, and, as such, they’re spending money.
Do Stocks Go Down When the Economy Slows?The economy can’t grow forever. If it did, prices (and inflation) would get insanely high. The economy goes through cycles every few years of growing and then not growing. Most companies make less money when the economy slows. Often, a recession occurs making matters worse. During a recession, jobs are lost and hence people spend less money. As a result, most stocks drop around recessions because earnings drop. It’s important to note that some stocks, however, benefit from a slower economy, while others at least continue normal earnings. This is because people must pay for some things no matter what the economy is doing, even when jobs are lost, for example. These company stocks often go up even though most stocks are going down simply because investors need someplace to put their money, and putting it into companies with good earnings makes sense. This dynamic, however, makes it trickier for investors to know if their stocks will go up or down since not all stocks move in tandem. What investors really want, though, is still earnings, and they will pay for those earnings, driving the price of some stocks up, even during a recession.
Do Stocks Go Up When Recessions End?Remember, stocks go up or down based on anticipation as much as current earnings. For this reason, stocks usually go up usually before the end of recessions. For example, the bottom of the 2007- 2009 bear market ended March 9, 2009. The recession ended in June 2009. In other words, stocks bounced hard off the bottom in anticipation of the recession ending. This is because investors were anticipating higher earnings in the near future after the horrible financial crisis! Since stocks go down related to recessions, they are often undervalued near the end of recessions. Based on history, this has usually been a good time to buy stocks before they go back up to more normal earnings multiple even though most investors are either afraid to jump back into the stock market, or their money is already tied up in stocks whose prices have dropped during the recession-related bear market. This means that the economy holds some excellent clues as to whether stocks will likely go up or down but there are other factors to consider which make it more challenging.
What Else Makes Stocks Go Up or Down?As noted earlier, there are several factors besides the economy that affect whether stocks go up or down.
Federal Reserve InterventionFederal Reserve actions influence whether stocks will go up or down. Here’s why. The Federal Reserve tries to keep the economy running smoothly. To do this, they lower interest rates to stimulate the economy when it slows. Alternatively, they raise interest rates to tame inflation when the economy grows too fast. This lowering of rates spurs economic growth, which increases earnings. Notice that we keep coming back to earnings because investors want and will pay for earnings. The Federal Reserve intervention helps avoids crises and recessions. Often, government stimulus packages also pour money into the economy. This additional intervention drives earnings even more. Too much intervention, however, can throw the normal pricing of stocks in relation to their earnings out of whack.
Investor PsychologyIn addition to Federal Reserve actions, as stock prices rise, investors become overexuberant about the stock market. FOMO (fear of missing out) sets in and investors throw money into the stock market at any cost as evidenced by a price earnings multiple that gets way over historical levels! Investors continue to pay increasingly higher multiples for earnings as greed sets in. At this point, investor psychology is driving the stock market so stock prices and their related earnings get even more out of whack. Eventually, a catalyst occurs that forces more normal pricing of stocks driving stock prices up or down. Normal pricing is reflected in the average PE ratio.
An Absence of Unexpected EventsThe stock market hates unexpected events, which are also known as Black Swans. When unexpected events happen, or when uncertainty increases, stock prices decline. When things appear normal and predictable stocks are more likely to go up.
When Will Stocks Go Up or Down, Exactly?No one knows exactly when stocks will go up or down. Every financial expert has an opinion about exactly when the stock market will change direction. Stocks tend to react to interest rate changes immediately, while the economy is not fully affected by interest rate changes for about a year. (1.) For comparison purposes, another important timing fact is that since 1945 through early 2010, the economy’s growth cycle has been just under 5 years. (2.) Click here to read my related post entitled How to Know if the Stock Market Will Go Up or Down.
Can You Really Know If Stocks Will Go Up or Down?It’s worth repeating that no one knows exactly when stocks will go up or down. There are ways, however, to tell if the economy is signaling change and thus manage stock risk better. Interest rate changes are a clear signal about shifts in economic growth. Again, the Federal Reserve increases rates to slow down the economy so inflation doesn’t get too high. The Federal Reserve lowers interest rates to help the economy grow during a recession. You can see that this is somewhat logical yet trying to predict stock market direction isn’t always logical due to investor psychology and other factors at work as you’ve seen here. By increasing your awareness of the price earnings multiple and overall economic happenings, however, you can manage stock market risk as a more informed investor. Click below to watch my video on how to know if the stock market will go up or down.
Summary: How to Know If Stocks Will Go UpHistory repeats itself even though there are always variations. Of course, no one knows for sure if stocks will go up or down within a specific time period. The longer the time period is, however, it’s logical to assume stocks will experience a bear market at some point during that period based on history. On the other hand, stocks have gone up over the long term despite the bear markets along the way.
The information on this website is for education only and is not to be construed as personal financial advice.