Four Reasons Why Stock Prices Move by Martti Luoma and Annukka Jokippi
Why do stock prices move?
IN a S&C December 2009 article titled “Gems Among The Talus,” Thomas Maskell outlined three reasons for stock price moves: growth, earnings, and money flow. He also discussed how those factors might be analyzed using technical analysis.
This article continues to explore that avenue of thought and presents another way of thinking about the causes of stock price moves, and also offers four reasons why stock prices move.
WHY AND WHAT?
Taking a cue from Maskell’s work, we decided to use a valuation model of stocks to provide a solid base to the analysis. We use the model first presented in S&C in May 2001 and later further developed by Luoma and Petri Sahlström elsewhere. Here are four ways that stock price moves are affected:
- Earnings per share
- Earnings growth
- Risk-free interest rate
- Equity risk premium
The first is earnings per share (EPS). A stock acquires value through its ability to make money for its holders in the present and a promise to do so in the future. Thus, the higher the EPS is, the higher the stock price goes. Future expectations also affect stock prices: for example, the growth rate of the EPS predicts the size. In practice, rapidly growing companies reflect rapidly increasing EPS. This is why earnings growth is second on our list of reasons for stock price moves.
Third on our list is a risk-free interest rate, which is also an important factor in the stock market. It controls price through fixing the interest rate on bonds and other instruments. Companies generally need to obtain finance from the market for investment purposes at some point in their development, and that influences the firms’ EPS and hence stock price. But bonds are also alternative investment objects for stocks, and the interest rate available also influences stock prices.
While the interest rate is low and money is cheap, demand for stocks increases as money flows into stocks. When money is cheap, firms see opportunities for bigger returns; for example, companies may invest in more effective machinery, be able to produce more and, as a result, earn more.
Market sentiment is also an important factor. While often mentioned, it is nonetheless difficult to define and measure. Consequently, Maskell adopted the concept of money flow rather than market sentiment, but we prefer to concentrate on equity risk premium, the fourth reason on our list. The basic rule is that if market sentiment is strong, the equity risk premium is small.