Can You Explain Why Stock Prices Move?

Ask a group of people that question and you will get a wide variety of answers.

Responses explaining market volatility may include:

These responses are certainly valid and are frequently mentioned in the media to explain market volatility. However, the problem for most investors is that frequently, stocks do the opposite of what logic would dictate. How often have we heard that home sales or retail sales dropped below historic lows and housing and retail stocks react in the opposite direction and go up. We may hear that unemployment numbers were the worst recorded in years yet market indexes go up that same day. It's important to realize that there's more to explaining short-term market movements than pure economic fundamentals.

Many reasons exist as to why stocks and markets move, but in the end, stock market movements can easily be explained by supply and demand. That is, supply and demand defined in terms of the human emotions fear and greed. When market participants are fearful, there's usually more supply fed by stock sellers and when greedy more demand by buyers. Fear and greed can be further stimulated by other factors. The macro- economic forces in play usually revolve around monetary liquidity, either easy money or tight money from the government. With that backdrop, other factors both fundamental and psychological come into play. Easy money will help housing and labor markets among others, but at the same time finds its way into markets to feed speculation. As markets start rising, market participants feel more confident. At this point momentum takes over driving short-term price swings. Investopedia defines momentum investing as a strategy that "looks to capture gains by riding 'hot" stocks and selling "cold" ones. To participate in momentum investing, a trader will take a long position in an asset, which has shown an upward trending price, or short sell a security that has been in a downtrend. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend." Clearly, this doesn't sound like fundamental investing even though its proponents usually find economic reasons to push stocks favored by momentum investors higher or lower.

In a new bull market, the only thing that has changed is that market players are willing to take on more risk than before. As prices improve, more investors join the action for fear of being left out. Rising prices lead to further price increases improving investor confidence until the trend finally exhausts itself. In a bear market, the opposite happens and declining prices lead to further declines until fear finally is so great that exhaustion sets in.

A common analogy would be a snowball rolling down the hill and getting bigger and bigger until it finally goes off a cliff, or a stampede of cattle starting with only a few animals and growing as the stampede picks up momentum. There are additional forces in play today like day trading, swing trading, and high frequency trading that have nothing to do with the underlying values of a company\u2019s stock and can accentuate current market trends. Thousands of traders and computer programs make buy and sell decisions solely on technical market patterns, blips, and charts and can account for up to 80% of daily volume in equity markets today. Of course, upside market momentum will not continue indefinitely if an economy is not improving and downward momentum will not continue indefinitely when it is improving. However, it can certainly continue for an extended period of time. Eventually, reality sets in and the economy has to improve to sustain a bull market and vice versa.

The old investment strategy of buy and forget about them hasn\u2019t worked for the last decade and most likely will not work in the future. New technological advances in computing and the internet allow rapidfire traders both human and machine, to impact and in some cases greatly distort daily market movements. Economic fundamentals long term are still important. However, having a better understanding of the role that short term speculation plays in markets will allow investors to avoid disaster and to eventually realize their savings and retirement goals. The bottom line: don't look to logic to explain daily market movements.

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