One of the first questions in the mind of any new stock investor is what are the causes of fluctuation of prices in the stock market? I wish that there was a simple answer to this question.
There are many ‘forces’ at play that govern the direction and the magnitude of the movement of the price of a share. While understanding these factors is possible, trying to predict the market is usually counterproductive. Nonetheless, today, I will be talking about why share prices change and look at factors that bring about this change.
In this article
The Demand Supply Equation
First things first, the share market is, well, a market. Hence, like any other market, the price of products being sold in the market is determined by the demand and supply of the said product. Let me give you an example:
During summer, most people in India buy products that help them fight the heat. Lemons are a huge favorite for fighting the heat. Hence, as summer approaches, the price of lemon increases two/three-folds.
Since the demand for lemons increases and the supply cannot match up to the increased demand, lemons become scarce in the wholesale market. Hence, retailers purchase lemons at a higher price to cater to the increasing demand in their market. This results in the price of lemons increasing from Rs.1/2 per piece to Rs.4/5.
Hence, an increase in demand plays a huge role in determining the price. The stock market is no different. If the demand for a particular stock increases for any reason, the stock price starts rising since every sale attracts more bidders making it imperative for them to bid higher to buy the share.
This results in an increase in the stock price. Similarly, if there is a drop in demand for a particular share, fewer bidders are attracted pulling the stock price low. I won’t get into the mechanics of how exactly the stock prices surge or drop.
With an investment perspective, it is important to understand that demand is the primary driver of the stock price. When demand exceeds supply, prices increase, and vice versa.
The next logical question is: what drives the demand or the drop in demand? What are the factors affecting share prices in the stock market?
Investors who can identify the factors that drive the stock prices up or down are in a better place to rebalance their portfolios efficiently. Before I start listing down the factors, there is another important fact that you need to know about the share market:
Investor or market sentiment drives the demand. The perceived risk of investing in a particular stock and/or the potential returns along with some external conditions together drive investor sentiment. Hence, you need to understand all these factors to understand how stock prices change. Let’s take a quick look at some important factors:
A share is an ownership in the company. Hence, any positive or negative company-related factors can impact the price of its stock. Here are some such factors:
- Any news or announcement regarding the present profits and earnings or predicted future earnings
- If the company declares dividends, it impacts the price of its shares
- Launch of a new product or the recall of a product
- A tie-up, merger, or takeover
- A significant change in the management of the company
- Any scams or scandals involving the company
- Layoffs or a major hiring spree
A positive announcement tends to boost investor sentiment leading to an increase in demand and thereby, the price.
Let’s say that an automobile company launches one of the cheapest cars in India. This can lead to a surge in car purchases in the country. Also, apart from the said car, people might also look at buying costlier cars based on their needs.
The point is that usually, if one industry or market segment thrives, then all companies from the sector can expect an improvement in business.
This reflects on investor sentiment and hence, the stock price. So, you can expect the stock prices of all companies from the automobile sector to rise.
Another possibility is that the sales of the cheapest car eat into those of costlier cars and negatively impact other companies from the sector. Hence, while the stock price of the company launching the cheapest car surges, the stocks of other companies from the sector crash.
Such industry-related factors can lead to a share price fluctuation.
3. Market Trends
You might have heard two terms repeatedly with respect to the stock market – Bull and Bear. These are not events but trends or phases causing a stock market fluctuation. A simple definition of these phases is as follows:
- Bull phase – This is a market trend where investors are optimistic about the future of the market and their confidence in the economy is rising. Hence, they tend to invest more leading to an overall increase in stock prices across all sectors.
- Bear phase – The opposite of a bull phase. In a bear phase, investors are worried about the future of the market and are uncertain about the direction in which the economy is heading. A good example is the current pandemic crisis where people are not sure when the economy will revive. Hence, stock prices tend to fall across all sectors.
Market trend affects companies regardless of their performance. These trends are usually rooted deep in some economic changes and can last for a few months.
4. Economic Factors
These factors can be analyzed, studied, and understood to make investment decisions for your benefit. I will talk about some important economic factors that you should not ignore:
Macroeconomics is the study of the behavior of an economy due to factors that impact the population as a whole and not individuals. In macroeconomics, geopolitical factors play an important role.
If there is an earthquake, then the country’s ability to produce and distribute goods can get affected. Also, it can cause physical damage to the infrastructure that would need time and money for repairs.
Hence, such an event can impact the economy and in turn the stock markets. There are various macroeconomic factors that impact stock markets like upcoming elections, war, civil unrest, natural disasters, or extreme weather conditions, political instability, etc.
Microeconomics is the study of individuals and companies due to factors that impact them. It does not take the overall economy into consideration. Some essential microeconomic factors are spending power of the customers of a particular company, availability of efficient distribution channels, availability of manpower, competitiveness in the segment, availability of investors, etc.
These factors determine how a company performs regardless of the way the economy is moving. Hence, even if the economy is booming but a certain sector does not have efficient distribution channels or availability of investors, then the sector will suffer leading to a drop in stock prices of all companies in the sector.
Inflation is a term that we use regularly without realizing its impact on everything around us. This includes stock prices. CPI or the Consumer Price Index measures retail inflation. It collects information about the changes in the price of the most common goods and services and computes the average cost of living in the economy.
The CPI is an indicator of the spending power of an individual. Inflation means a rising price regime or an economy where the prices of goods/services are constantly rising.
Hence, people will have to ensure that their income rises in sync to maintain their quality of life. A sudden rise in inflation rates can impact the stock markets negatively since it reduces the spending power of investors.
MPC Interest Rates
The Monetary Policy Committee (MPC) of India determines the borrowing and lending rates in the country. If the borrowing rates increase, then companies have a higher debt expense leaving fewer funds for growth and expansion.
This can impact the future cash flow of the company and lead to a drop in share prices. While a gradual increase in interest rates is considered healthy, a sharp rise can hurt businesses. This can be sector-specific too.
For example, an interest rate hike can benefit the financial services sectors causing a rise in stock prices. Overall, interest rates are one of the most important factors that impact the stock market
GDP or Gross Domestic Product is the total amount of goods or services produced by an economy. In layman terms, GDP is an indicator of the health of an economy.
Usually, a strong GDP growth means businesses experience better earnings and indicates a positive economic outlook. Hence, investor confidence is high and stock markets surge. However, since GDP is an indicator of how the economy performed in the past, its impact on stock markets is not as severe as the other factors.
While I tried to list some of the common reasons for fluctuation in the Indian stock market, it is important to remember that every stock purchase is unique and the price variations will be impacted by the conditions prevalent then. While understanding each factor is important, with years of experience, you will be able to understand the cumulative effect of all such factors on stock prices. Hence, it is nearly impossible to predict the direction the stock price will take. However, understanding these factors can help you make some important investment decisions. Good Luck!
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