How and Why do Stock Markets and Stock Prices Rise and Fall?

If you’ve spent any time watching the Canadian and U.S. stock markets, you know that stock prices are constantly fluctuating. Prices can be up one minute, and the down the next. A basic understanding of why stock prices are always changing will help you to make more confident investment decisions.

The law of supply and demand is the simplest explanation for rising and falling markets, and for changing stock prices. If there are more investors willing to buy a stock than sell it, the stock price will go up.

A catalyst is defined as any event – whether it is good news or bad news – that triggers investors to buy or sell stock. This, in turn, can dramatically drive stock prices up or down. A catalyst can take the form of a new product launch, an influential analyst’s assessment of a company, a lawsuit, an earnings report, a corporate scandal – or something truly unanticipated like the coronavirus (Covid-19) pandemic.

We’ve grouped a variety of catalysts under two main categories: fundamental factors and technical factors.

Company earnings can heavily influence a stock’s rise or fall, but earnings alone won’t tell you everything you need to know. Knowing the fundamentals will give you a better understanding of the value of a company.

Ultimately, by analyzing the fundamentals, you can assess whether the current stock price represents good value. (The other key set of factors – technical factors – will be covered in the next section.)

Here’s what to look for when you’re considering a fundamentals-based investment strategy:

Company earnings

Impressive earnings, or profits, are a factor when evaluating stock value. There are legions of investors, financial advisors and analysts on Bay Street and Wall Street who closely watch public companies’ earnings reports.

If a stock beats analyst estimates, the price of the stock may rise based on the good news. But realize that doing incrementally better than expected is common in the stock market. Most stocks tend to do that. You may see a more significant rise in a stock price if earnings significantly out-perform analyst projections.

One the opposite side of the table, every investor and trader dreads the earnings miss. It can lower the value of the company, and will almost certainly impact the stock negatively – often quite significantly.

Earnings per share (EPS)

Earnings per share is a company's profits divided by the number of shares outstanding. As the owner of stock, you have a claim on earnings, and earnings per share represents your return on investment. The higher the earnings per share, the better for you as an investor. EPS, regarded as the bottom line for many analysts, investors and and traders, is considered one of the most important factors in determining a stock’s true value.

P/E (price-to-earnings) ratio

Another important consideration is the P/E ratio, which compares the current price of a stock to its per-share earnings. A higher P/E ratio typically means that investors will pay more for the stock because they expect continued growth from the company.

Dividend yield

The dividend yield is the annual dividend per share divided by the stock's price per share. For instance, say a company’s stock trades at $15 and its annual dividend is $1.25. The dividend yield in this case would be 8.3%.

Other fundamental factors include:

• Projected earnings growth helps determine a stock’s value by anticipating the one-year earnings growth rate.
• Price-to-sales ratio (P/S) evaluates stock value by comparing its price with company revenues.
• Price-to-book ratio (P/B) compares a stock's book value to its market value.
• Dividend payout ratio factors in a company’s total net income and compares to dividends paid out to stockholders.

Launch of new products or services

If you get excited about the newest generation of smartphone or the latest model of electric car, you’re not alone. A new product may bring in a fresh source of revenue, which is an attractive selling point to many investors.

Analysts, however, take a more measured approach. They may question a new product that doesn’t appear profitable. Or they may question the long-term potential of a stock because a new product is notably inferior to a competitor’s.

Companies can actually lose contracts, products or brands. For instance pharmaceutical company that has a profitable drug patent expire may see its stock price impacted.

Brokerage and analyst upgrades or downgrades

As discussed earlier, positive and negative earnings reports from public companies can have dramatic effects on stock prices, driving them up or initiating a sell off. A major Wall Street and Bay Street brokerage or analyst – and even influential investors like Warren Buffet -- can have a similar impact on stock prices. Look for a Buy or Sell rating to learn how an analyst feels about individual stocks.

Other factors that could affect industry professionals’ perspectives on a stock include:

• The announcement of dividends
• Significant employee layoffs
• Executive turnover
• Accounting errors and other scandals
• Lawsuits against the company

Acquisitions/takeovers and mergers

We’ve seen some spectacular takeovers, or acquisitions, and mergers over the past few decades. Few news items can dominate front pages – or impact stock prices – like takeover bids. The bigger the companies involved, the more attention the proposed deal will draw. The acquiring company may use its own stock, cash or a combination of both in order to takeover the target company.

The good news for a under-performing company? It could see its stock price go up immediately if it is the target of a takeover.

It would be ideal if investors could evaluate a stock’s current – and future – value on fundamentals alone. But the fact is, there are many external criteria that could impact the supply and demand for a certain stock. These are known as technical factors.

What are some of the key technical factors that you should consider as you plan your investment strategy?

Inflation and deflation

Inflation leads to higher consumer prices, which will often slow a company’s sales. In a high inflation environment, the Bank of Canada (or United States Federal Reserve) may decide higher interest rates are a good way to slow the impact of rising prices. The changes could lead investors to more fixed income investment options, thereby lowering stock prices. Falling prices, or deflation, can also lower a company’s profits. Again, investors may increasingly choose vehicles like bonds over stocks.

The state of the economy

Generally speaking, two factors indicate the health of a nation’s economy: its growth rate and unemployment rate. Investors may respond to a growing economy by buying stocks because they anticipate higher prices and dividends. They may sell stock if the reverse is true – the economic outlook isn’t rosy.

Substitutes

Stocks are not, of course, your only investment options. You can choose government bonds, corporate bonds, real estate and foreign equities, among many others. How these perform in relationship to equities will trading volume on the markets.

Thriving sectors

A rising tide lifts all boats. Even if the earnings are not there, a company could get the benefit of the doubt if they are part of a fast-growing sector or industry. Investors will buy because they believe that the sector – and many of the companies within it – have promising futures.

Pullbacks and market corrections

You’ll hear these terms quite a bit if you follow the stock market. They’re not as alarming as they may sound. In fact, pullbacks are especially common.

Sometimes, the market gets “overextended”. This happens when overly enthusiastic investors push stock prices beyond reasonable limits. The pullback will kind of reset pricing to more normal levels.

A market correction is a pullback on steriods. Technically, it is defined as a 10% drop in stock prices.

Both both pullbacks and market corrections represent opportunities to buy stocks at a lower price. But it’s smart to know the difference between a pullback, market correction and a longer-term download trend in stock prices.

Changing regulations, laws and societal preferences

If wasn’t that long ago when cigarette smoking was a tolerated – and profitable – societal norm. While health was the key driver for the decrease in smoking, stricter anti-smoking laws played a big role, too.

Cannabis, an illegal and frowned-upon product for decades, is now one of the hottest sectors in Canadian investment history – thanks to government legalization of cannabis in 2018.

Similarly, stock prices can be driven up or down based on other changes in regulations and laws, such as trade deals between countries.

Economic and political shocks

In an era of globalization it stands to reason that events thousands of kilometres away from Canada can impact both our economy and stock market. The list of economic and political shocks is extensive: rising energy costs, policy changes, trade wars, terrorism, military conflict and regime change. And then there sudden seismic global events that no one saw coming, such as the coronavirus pandemic.

The value of the Canadian dollar

Every company, including homegrown entities, are impacted by globalization. A case in point: if our dollar’s value increases, customers outside of our borders will expect to spend more on Canadian goods and services. That may decrease a company’s sales, and thus negatively impact its stock price. Of course, the opposite is true. When the Canadian dollar falls, our goods become cheaper. Sales may increase, driving stock prices up.

Interest rates and monetary policy

The Bank of Canada and United States Federal Reserve use interest rates to stimulate or stabilize shifts in the economy. If you’ve ever leased a car or purchased a home there’s no doubt you appreciate the importance of interest rates! Companies are no different from consumers in this regard. The company that borrows money at a higher interest rate will experience a heavier debt load, which could send its stock falling. Another by-product is lower dividend payments to its shareholders, a definite bad look in the world of investing.

There’s no doubt that good news or bad news can influence share prices. If there’s a new government economic report suggesting that Canada’s economy is growing at a good clip, it will likely boost demand for stocks, and increase prices.

In addition to economic reports, there are other topics that will grab the attention of the investing community: quarterly financial reports, disruptive global events, mergers and acquisitions, political tensions, medical breakthroughs, trade deals, new products, executive shake-ups in corporations, the list goes on and on.

Experienced investors tend to not over-react to any single news item. Rather, they’ll look at the economy and their portfolio goals in totality, adjusting their investment strategy to keep them on track.

Market sentiment, or investor sentiment, is a loose measurement of investor optimism in the economy, or confidence in the Canadian and U.S. stock markets. Are they feeling positive and hopeful? Or cautious and nervous?

You wouldn’t think that emotions could influence share prices that much, but they do all the time. Think about it from own perspective. If you’re not feeling positive about the economy, you’re likely to avoid the stock market. The result: stock prices go down.

If the economy is doing well and you feel secure in your job, you may consider investing more in individual stocks and mutual funds. If there are enough investors who feel as optimistic as you do, stocks will surge.

Which brings us to bull and bear markets.

A bull market is a period of time in which stock prices are steadily rising. Two of the major factors that give rise to a bull market is a strong economy and high employment rates. Both contribute to investor optimism, propelling stock prices skyward.

Some of the common investment tools and strategies used during bull markets:

• Long positions is the purchase of a particular stock with the expectation that its price will continue to rise
• Longer exchange traded funds (ETFs) strive to replicate the movement of stock indices, like the S&P/TSX, NASDAQ or the Dow Jones Industrial Average Index
• Call options give the investor the right to buy a stock at a pre-determined ‘strike price’ until a specified date. For example, if the stock rises over and above the call option’s strike price, the investor has the option to buy it at the lower price; presumably, they will sell it at a higher stock price later on

A bear market is the opposite of a bull market: it is a period of time characterized by declining stock prices. During bear markets, investors are nervous about the economy or anxious about their jobs since unemployment rates tend to be higher than during bull markets.

Some of the common investment tools and strategies used during bear markets:

• Short selling (or short positioning) is when investors “borrow” stock from brokerage firms in anticipation stock prices falling in the future. If the price does indeed decline, the investor will buy the stocks at the lower price to cover the short position and then make a profit on the difference. Shorting requires margin loans which come with interest charges that the investor pays for the life of the position. The potential for loss is significant, so short selling is not recommended for any investor that is not extremely knowledgeable and experienced
• Put options give the investor the right to sell a particular stock at a specific strike price until a future date. The value of the option increases as the individual stock price decreases. If the stock moves below the put option’s strike price, the investor can exercise the right to sell the stock at the higher strike price or they can decide to sell the put option and see a profit
• Short, or inverse, exchange traded funds (ETFs) generate returns in a similar way to short selling. ETFs are ‘borrowed’ with the expectations that stock prices will continue to fall. They move in the opposite direction from their underlying indices. Caution is advised as this is a sophisticated and risk-laden investment tool.

The stock market tends to repeat certain seasonal trends year after year. The fabled “Santa Claus Rally” in December is just one example. During these time periods, share prices can be especially volatile.

What’s behind it these periodic shifts in stock market activity? The reasons range from less trading during the summer months to more trading as the tax year comes to an end. Let’s take a look at the most significant of these phenomena :

Time periods with more trading activity

• January Jump – when investors have new capital to invest; many will claim that the January Jump is a predictor of market performance for the rest of the year
• Pre-Holiday Effect – share prices can rally ahead of long weekends as optimistic investors look forward to an extra long breather

Time periods with less trading activity

• Summer - stock prices fall as investors and traders concentrate on their holidays

Time periods that can lead to more stock price volatility

• End of quarter - this surge in trading activity is driven by large scale investors who bid aggressively on stocks
• End of tax year – a time when investors sell stocks that are under-performing so they can claim capital losses
• Mondays & Fridays – share prices can dip at the beginning of the week and go up at the end of the week

The bottom line is this: all investment vehicles, whether individual stocks, bonds, mutual funds and so on, fall or rise as a result of many different factors. Sharp investors will want to pay especially close attention to the short-term and long-term market movements. Is it a result of a one-time catalyst? Or a combination of factors driving stock performance? Is it overall market downward trend? Or simple (and normal) day-to-day price fluctuations? The best investment decisions are always the ones based in knowledge and experience.