Why do stock prices move?
In this issue, we look at the two main reasons behind the movement of stock prices. Of businesses, roller coasters, cycles, emotions--and more!
Is it magic? Madness? Both?
Why do stock prices move like a roller coaster? I mean—just look at this. The stock price of MCX has almost tripled in six months. Why?
It's not magic. It's a bit of math and lots of emotions.
The stock price, like all prices is a function of demand and supply.
Like the price of onions? Yes. Now you know the price of Onions is a roller coaster, don’t you?
Let's dive into the reasons behind the movement of stock prices in Issue #04 of The New Investor Series!
Why do stock prices go up and down?
All the reasons behind the movement of stock prices can be combined into the following two MEGA reasons.
Economic changes, wars, crude oil prices, interest rates—you name it, and it will fall under one of these.
Let’s go.
1. Changes in the Underlying Business
If you've been following The New Investor Series, by now you know that stocks are nothing but ownership of a business. We talked about it here—What is a stock?
If the business does well, the demand for its stock will increase—as more people want to own it, they will rush in to buy its stock.
If the number of shares being offered for sale remains the same— demand will be more than the supply.
The Price moves upwards. Economics 101. Demand and Supply.
If the business deteriorates, the demand for its stock goes down; people sell its stock in droves—and the supply starts to exceed its demand.
The stock price falls. So far so good. But, prices don’t just reflect the actual changes in a business.
Enter Humans—the pesky little emotional rascals!
Humans lead us to the second reason.
2. Annoying Humans and their Expectations
Humans can't sit still. If you’re not an alien reading my oh-so-popular blog, you probably know this already.
As soon as we humans found out that stocks can make us rich—we’ve tried to predict how their prices will change.
While calculating the motions of heavenly bodies, we also tried to calculate how the future will turn out for a business. Greed and Fear entered the picture.
You've heard the phrase:
Expectation is the root cause of all suffering.
I want to modify this a bit for the stock market.
Expectation is the root cause of all suffering and all joy.
Emotions can impact the prices of stocks. Falling prey to irrational emotions leads to suffering, and having the resilience to act against the herd—leads to joy.
Imagine this:-
The economy and companies are doing well
There is a feeling of optimism
People are buying stocks
Stocks are going up, and people are buying more stocks
Joy.
People are throwing caution to the wind and are willing to bet their houses on the stock market. Risk aversion goes for a toss.
Soon, economies and companies start doing "too well". Our psychologically error-prone brains extrapolate this feeling of optimism into the future and start paying more for the same businesses.
The pendulum swings to stocks being 'flawless'.
Soon, everybody who can buy stocks has bought some. The demand tapers off at some point and eventually becomes less than the supply of stocks.
What happens when supply exceeds demand?
Trends create the reasons for their reversals.
The path of optimism that we saw is inverted.
As prices fall, confidence is shaken
Company earnings don't live up to the expectations
People start selling stocks, prices go down, people sell more
Fear
The pendulum swings to stocks being 'hopeless'.
BUT
Trees don't grow to the sky, and things rarely go to zero.
— Howard Marks
Stocks will eventually become "too cheap", and the upcycle will begin again.
If you didn’t read the rant above, look at this graphic I made.
The two lines in the above graph, represent the two reasons behind the movement of stock prices.
The yellow line—is reason #1. It shows how businesses (hopefully) grow over time. It shows the fair value of the business growing.
The blue line—reason #2, shows the change in investors’ perception. People becoming extremely greedy, extremely fearful, and feeling all emotions that lie somewhere in the middle.
Almost always, the stock price overshoots in both directions. It exceeds fair value due to euphoria on the way up and becomes cheaper than its fair value due to pessimism—on the way down.
How to think about stocks?
By looking into why stock prices move, one thing is clear. Understanding businesses and investor psychology is a requirement for investment success.
To have a decisive edge:
You have to find businesses that will grow over time
This is the yellow line trending upwards. If you can zero in on a business sure to grow in the future, half the job is done.
Get good at identifying growing companies and sectors.
AND
Buy these businesses when their stock price is relatively cheap
You have to buy these businesses when their stock price is less than their fair value—when the blue line is well below the yellow line. This happens due to pessimism, fear, and undiscovery.
Find a company with a good future, and buy it when it is cheap.
At The Investment Compass, we regularly look at new businesses, sectors, and trends. We will also learn how to value companies so that you can ascertain their fair value yourself!
The Library
Taking inspiration from Shankar Nath’s Substack, I am starting The Library section of The Investment Compass. Here, you will find interesting books to read, reviews of books that I am reading, and other interesting stuff to read.
My recommendation for this week is a book written by Howard Marks, the legendary investor and founder of Oaktree Capital Management, a firm managing more than $150 billion.
Mastering the Market Cycle focuses on various cycles that impact the market and stock prices. Howard Marks provides frameworks for analyzing where we are in the current stage of these cycles and how to position your portfolio accordingly.
Do Read!